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AMERICAN    SOCIETY 


OF 


CIVIL  ENGINEERS 


THE  AFI^RAISAL  OF 

PUBLIC  SERVICE  PROPERTIES 

AS  A  BASIS  FOR  THE  REGULATION  OF  RATES. 


BY 


C.  E  Grunsky,  M.  Am.  Soc.  C.  E. 


WITH    DISCUSSION    BY 


Mkssrs.  WILLIAM  BROKAW  BAMFORD,  JAMES  V.  OXTOBY, 

CHARLES   H.   HIGGINS,    HENRY   FLOY, 

J.  MARTIN  SCHREIBER,  WILLIAM  J.  BOUCHER,  R.  D.  COOMBS, 

A.  H.  VAN  CLEVE,  W.   KIERSTED,   and  C.  E.  GRUNSKY. 


Reprinted  from  Trnnsacfinnx,  Vol.  LXXV.  p.  770  (1912). 


9'7 


Compliments  of  t-„am 

AMERICAN   ENGINEERING   CORPORATION 

f\\    |C.I\IV^/-vi^  ORUNSKY.  President 


Mechanics  institute  Building 

57  Post  street.  San  Francisco 


AMEEICAN  SOCIETY  OF  CIVIL  ENGINEERS 

INSTITUTED    1852 


TRANSACTIONS 


Paper  No.  1232 

THE  APPEAISAL  OF 
PUBLIC   SERVICE   PROPERTIES 
AS  A  BASIS  FOR  THE  REGULATION  OF  RATES.* 

By  C.  E.  Grunsky,  M.  Am.  Soc.  C.  E. 


With  Discussion  by  Messrs.  William  Brokaw  Bamford,  James  V. 

OxTOBY,    Charles    H.    Higgins^    Henry    Floy,    J.    Martin 

Schreiber,  William  J.  Boucher,  E.  D.  Coombs,  A.  H. 

Van  Cleve,  W.  Kiersted,  and  C.  E.  Grunsky. 


Introduction. 

It  is  the  purpose  of  this  paper  to  make  clear  the  fact  that  appraisals 
of  public  service  properties  for  rate-fixing  purposes  can  be  made, 
with  advantage  to  all  parties  concerned,  vs'ithout  deducting  anything 
from  the  properly  invested  capital  for  deprecia.tion.  Incidentally,  it 
will  be  pointed  out  that  depreciation  must,  and  how  it  should,  be 
taken  into  account  in  estimating  net  earnings;  that  appreciation 
should  be  regarded  as  a  reinvestment  of  earnings;  and  that  there  is 
and  can  be  no  definite  basis  for  such  elements  of  value  as  "going 
concern"  and  the  like,  unless  operations  are  conducted  under  a  restric- 
tive franchise,  that  is,  unless  the  franchise  frees  the  public  service 
corporation  from  outside  control  of  its  rates.  No  apology  need  be 
made  for  the  elementary  treatment  of  parts  of  the  subject. 

The  appraisal  of  public  service  property  for  various  purposes,  such 
as  taxation,  regulation  of  rates,  purchase,  and  limitation  of  indebted- 
ness is  receiving  attention  by  many  engineers  and  financial  experts  at 
the  present  time. 

*  Presented  at  the  meeting  of  June  5th,  1912. 


THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES  771 

Ideas  in  the  matter  of  valuation,  both  in  relation  to  what  should 
be  included  in  the  valuation  and  to  the  valuation  itself,  are  so 
diverse  that  a  few  words  about  the  fundamental  principles  which 
should  control  when  the  appraisal  of  a  public  service  property  is  to 
serve  as  a  basis  for  fixing  the  rates  to  be  charged  for  the  service,  are 
now  offered  in  the  hope  that  what  is  presented  may  aid  in  unifying 
methods  of  computing  the  desired  earnings  and  in  overcoming  some 
of  the  difficulties  into  which  the  Courts  are  leading  the  experts. 

The  definite  programme  herein  indicated  for  dealing  with  deprecia- 
tion and  amortization  is  the  outcome  of  the  writer's  professional 
employment  in  California  on  appraisals,  representing,  at  various 
times,  the  rate-payers,  and,  at  other  times,  the  owners  of  public  service 
properties. 

No  attempt  will  be  made  to  apply  the  conclusions  reached  to 
valuation  for  other  purposes  than  the  regulation  of  rates,  nor  to  valua- 
tions in  those  cases  in  which  special  privileges  have  been  granted,  in 
which,  therefore,  the  franchises  are  in  the  nature  of  an  agreement  or 
contract.  Neither  is  it  proposed  to  deal  with  any  cases  out  of  the 
ordinary,  such  as  those  in  which  the  owner  of  a  property  was  aided 
by  bond  issues,  land  grants,  and  the  like.  The  main  purpose  will  be 
kept  in  view  of  presenting  a  clear  analysis  of  the  fundamental  problem, 
so  that  an  understanding  may  be  had  of  the  principles  which  should 
prevail  whenever  an  appraisal  is  made  for  rate-regulation  purposes. 

The   Law   in    California. 

The  following  is  from  the  Constitution  of  the  State  of  California 
(in  effect  January  1st,  1880)  : 

"The  use  of  all  water  now  appropriated,  or  that  may  hereafter 
be  appropriated,  for  sale,  rental  or  distribution,  is  hereby  declared  to 
be  a  public  use  and  subject  to  the  regulation  and  control  of  the  State, 
in  the  manner  to  be  prescribed  by  law;  provided,  that  the  rates  or 
compensation  to  be  collected  by  any  person,  company  or  corporation  in 
this  State  for  the  use  of  water  supplied  to  any  city  and  county,  or 
city  or  town,  or  the  inhabitants  thereof,  shall  be  fixed  annually  by  the 
Board  of  Supervisors,  or  city  and  county,  or  city  or  Town  Council, 
or  other  governing  body  of  such  city  and  county,  or  city  or  town,  by 
ordinance  or  otherwise,  in  the  manner  that  other  ordinances  or  legisla- 
tive acts  or  resolutions  are  passed  by  such  body,  and  shall  continue  in 
force  for  one  year  and  no  longer.  Such  ordinances  or  resolutions  shall 
be  passed  in  the  month  of  February  of  each  y^ar,  and  ,t.ake  effect,  on 
the  first  day  of  July  thereafter. 


773  THE  APPEAISAL  OF  PUBLIC  SERVICE  PKOPERTIES 

"The  right  to  collect  rates  or  compensation  for  the  use  of  water 
supplied  to  any  county,  city  and  county,  or  town,  or  the  inhabitants 
thereof,  is  a  franchise,  and  cannot  be  exercised  except  by  authority  of 
and  in  the  manner  prescribed  by  law. 

"In  any  city  where  there  are  no  public  works  owned  and  controlled 
by  the  municipality,  for  supplying  the  same  with  water  or  artificial 
light,  any  individual,  or  any  company  duly  incorporated  for  such 
purpose  under  and  by  authority  of  the  laws  of  this  State,  shall,  under 
the  direction  of  the  Superintendent  of  Streets,  or  other  officer  in 
control  thereof,  and  under  such  general  regulations  as  the  muni- 
cipality may  prescribe  for  damages  and  indemnity  for  damages,  have 
the  privilege  of  using  the  public  streets  and  thoroughfares  thereof, 
and  of  laying  down  pipes  and  conduits  therein,  and  connection  there- 
with, so  far  as  may  be  necessary  for  introducing  into  and  supplying 
such  city  and  its  inhabitants  either  with  gas  light,  or  other  illuminat- 
ing light,  or  with  fresh  water  for  domestic  and  all  other  purposes, 
upon  the  condition  that  the  municipal  government  shall  have  the  right 
to  regulate  the  charge  thereof." 

The  charter  of  the  City  and  County  of  San  Francisco  (in  effect 
January  8th,  1900)  mentions,  among  the  powers  of  the  Supervisors: 

"To  fix  and  determine  by  ordinance  in  the  month  of  February  of 
each  year,  to  take  effect  on  the  first  day  of  July  thereafter,  the  rates 
of  compensation  to  be  collected  by  any  person,  company  or  corporation 
in  the  City  and  County,  for  the  use  of  water,  heat,  light  or  power, 
supplied  to  the  City  and  County  or  to  the  inhabitants  thereof,  and  to 
prescribe  the  quality  of  the  service." 

General   Kemarks. 

The  value  of  a  revenue-producing  property  is  determined  ordi- 
narily by  its  earning  capacity;  but  this  earning  capacity,  when  it  is 
to  be  used  as  a  basis  for  valuation,  must  itself  be  determined  with 
proper  consideration  of  all  attendant  circumstances.  It  is  not  enough 
to  compare  receipts  with  current  expenditures  when  estimating  net 
returns.  Account  must  be  taken  of  the  useful  life  of  the  property, 
because,  in  order  that  the  property  may  be  kept  at  a  standard  service- 
ability, parts,  or  all  of  it,  must  be  replaced  from  time  to  time,  unless 
indeed  it  happens  to  be  of  a  character  similar  to  real  estate,  having 
for  all  practical  purposes  a  perpetual  life.  Such  circumstances  as 
appreciation  in  value  which  may  arise  from  an  advance  of  real  estate 
values,  or  from  other  causes,  must  also  be  taken  into  account. 

Knowing  the  earning   capacity   and  the   ordinary   interest   return 


THE  APPRAISAL  OF  PUBLIC  SEEVICE  PROPERTIES  773 

expected  from  an  investment,  it  becomes  an  easy  problem  in  mathe- 
matics to  capitalize  earnings,  it  being  understood  that  no  necessary 
expenditure,  present  or  prospective,  has  been  overlooked,  and  that,  in 
estimating  useful  life  and  the  requirements  of  an  amortization  or  a 
replacement  fund,  every  factor,  such  as  ordinary  deterioration,  inade- 
quacy, and  obsolescence  due  to  advance  in  the  arts,  shall  have  been 
given  due  weight  and  consideration. 

In  the  case  of  properties,  however,  the  earnings  of  which  are  sub- 
ject to  regulation,  an  element  of  uncertainty  concerning  the  amount 
of  earnings  may  be  introduced,  rendering  it  impossible  to  use  earn- 
ings as  a  basis  for  computing  value. 

Cases  do  occur  in  which  franchises  are  exclusive,  and  in  which 
rates  for  services  rendered  remain  operative  for  long  periods  of  time, 
in  which,  therefore,  even  under  a  system  of  rate  regulation,  it  is 
possible  to  estimate  earnings  for  long  future  periods  and  in  which  the 
earnings  are  determinable  with  sufficient  precision  to  be  used,  in  some 
measure  at  least,  in  determining  value;  but  this  is  not  so  in  Cali- 
fornia. There  the  system  of  annual  rate  fixing  prevails,  and  the 
maximum  rates  allowed  are  presumed  to  be  fixed  so  that  under  them 
there  may  be  a  fair  return  to  the  corporations  on  the  value  of  the 
properties  actually  in  use  in  rendering  the  service.  Perhaps  the  use 
of  the  term,  "value,"  in  this  connection  is  unfortunate,  because  it  is 
not  clear  why  "value,"  as  ordinarily  defined  (which  is  not  always 
synonymous  with  capital  reasonably  and  properly  invested),  should 
be  made  the  criterion  of  allowable  earnings.  It  is  reasonable  to 
assume  that  the  term,  "value,"  in  connection  with  the  fixing  of  rates, 
has  been  used  without  prejudice  to  the  rights  of  the  owner  of  a  public 
service  property,  and,  therefore,  some  note  will  be  taken,  in  what  is 
here  presented,  of  value  as  it  may  appear  from  different  standpoints. 

It  is  not  necessary  to  state  that,  in  a  critical  analysis  of  earnings, 
which  go  in  part  to  an  amortization  fund  and  are  in  part  dis- 
tributable as  a  return  on  the  investment,  the  rate  of  interest  taken 
into  account  should  be  the  same  throughout.  When  it  shall  have 
been  determined  in  any  particular  case  what  the  earnings  must  be  to 
yield  the  same  rate  of  return  as  could  be  obtained  from  ordinary  safe 
investments,  then  any  desired  addition  as  compensation  for  having 
undertaken  the  operation  of  the  public  service  property,  or  for  un- 
usual risk,  may  be  added. 


774  THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES 

Useful  Life,  Value,  Depreciation,  and  the  Amortization  Fund. 

The  general  presentation  of  the  problem  will  be  simplified  by 
assuming  that  the  actual  useful  life  or  service  of  a  plant,  or  part  of 
a  plant,  conforms  in  every  case  exactly  to  its  expectancy^  That  this 
is  not  in  reality  the  case,  and  how  it  affects  the  conclusions  which 
otherwise  would  be  reached,  will  be  referred  to  later. 

In  the  presentation  of  the  subject,  this  assumption  has  been 
strictly  adhered  to,  and  the  rate  of  interest  uniformly  applied  is  4% 
per  annum. 

Take  the  case  of  a  plant,  every  part  of  which  has  a  life  of  20 
years,  all  constructed  at  one  time  and  owned  by  a  prudent  owner 
who  sets  apart,  as  an  amortization  fund,  each  year  $0.03358  for  every 
dollar  invested  therein  at  an  interest  of  4%  per  annum.  If  the 
plant  is  one  which  will  actually  net  4%,  then  the  apparent  excess  of 
the  earnings,  including  amortization,  over  expenses,  should  be 
4  +  3.36  =  7.36%,  and  the  owner,  in  estimating  the  price  at  which 
he  can  sell  without  loss  at  the  end  of  any  period,  as,  for  example,  at 
the  end  of  10  years,  would  figure  as  follows  (for  each  $100  of  original 
investment)  : 

Investment   $100.00 

In  the  amortization  fund:  being  the  amount  of  a 

10-year  annuity  of  3.358%  at  4%  interest.  .        40.30 


Remaining   value ,.^..^^^^ . ^^^,^   $59.70 

A  prospective  purchaser  would  figure  that  the  plant  should  be 
worth  at  least  as  much  as  the  annuity  of  3.358%  would  amount  to  in 
the  remaining  years  of  the  plant's  life. 

The  amount  of  a  10-year  annuity  of  $3,358  is  $40.30,  and  to  this 
amount  he  would  add  a  sum  determined  from  the  excess  earnings  of 
the  plant  over  a  net  earning  of  4%  during  its  remaining  life  on  the 
part  of  the  value  which  he  has  estimated,  as  explained,  on  the  amor- 
tization or  retirement  fund  basis. 

The  earnings  being  based  on  4%  of  the  originally  invested  capital, 
the  increment  of  value  covered  by  the  amortization  fund  being  $40.30, 
on  which  4%  is  $1,609,  for  10  years  there  will  be  earned  an  additional 
$2,391  per  annum,  of  which  the  present  value  is  $19.40.  The  pur- 
chaser, therefore,  will  conclude  that  he  can  invest  with  assurance  of  a 
4%  net  return,  $40.30  +  $19.40  =  $59.70. 


THE  APPRaIsAL  OF  PUBLIC   SERVICE  PROPERTIES  775 

Of  course,  the  same  conclusion  could  have  been  reached  by  deter- 
mining the  present  value  of  the  earnings  treated  as  an  annuity  of 
$7,358  for  the  remaining  10  years,  which,  at  4%  per  annum,  is  $59.70. 

At  the  end  of  10  years,  the  original  owner,  keeping  for  his  own 
use  the  money  in  the  replacement  fund,  will  be  satisfied  to  sell  at 
$59.70.  The  purchaser,  content  in  this  case  with  the  assumed  rate 
of  interest  of  4%,  will  be  willing  to  pay  this  $59.70,  because,  at  the 
end  of  the  plant's  useful  life,  he  will  have  recovered  his  investment 
with  4%  interest  compounded  annually.  He  will  then  be  under  the 
necessity  of  replacing  the  plant,  making  a  new  investment  of  $100,  as 
the  original  owner  would  have  been  if  he  had  remained  in  possession. 

During  the  entire  20  years  of  usefulness  the  plant  has  been  render- 
ing adequate  service.  The  sufficiency  of  the  service  is  independent 
of,  and  bears  no  relation  to,  the  useful  life  of  the  plant,  nor  to  the 
fact  that  it  was  gradually  deteriorating.  During  all  periods  of  the 
plant's  life,  the  depreciation  of  its  physical  elements  was  offset  by  the 
accumulation  in  the  amortization  fund. 

Of  course,  it  cannot  be  known  just  how,  nor  at  what  rate,  the 
actual  deterioration  of  a  plant  takes  place.  This  may  be  rapid  at 
some  period  of  its  life,  and  slow  at  another,  but,  as  it  is  supposed,  at 
all  times  during  its  life,  to  be  adequately  performing  the  service 
expected  of  it,  this  rate  of  decay  is  entirely  immaterial. 

In  other  words,  the  amortization  may  be  determined  without 
regard  to  the  physical  condition  of  a  plant  at  any  period  of  its  life, 
provided,  of  course,  that  the  plant  fulfills  the  requirements  of  adequate 
service  at  all  times  of  its  life.  For  this  reason  it  has  become  con- 
venient to  consider  the  actual,  or  the  theoretical,  accumulation  in  an 
amortization  fund  as  the  measure  of  plant  depreciation  with  a  conse- 
quent interchange  of  terms,  which  has  led  to  a  quite  general  use  of 
the  term,  "depreciation,"  when  designating  the  retirement  of  invested 
capital. 

There  is  a  clear  distinction  between  amortization  and  replacement. 
The  amortization  deals  with  the  repayment,  of  the  original  investment. 
This  may  be  in  installments  in  uniform  or  unequal  annual  amounts, 
or  in  a  lump  sum  at  the  end  of  useful  life.  The  replacement  may 
mean  the  substitution  of  a  new  identical  plant,  but  at  a  cost  dependent 
on  new  conditions,  new  prices  of  labor  and  material,  or  it  may  mean 
the    substitution    of    new    devices    rendering    equivalent    service.      In 


776  THE  APPRAISAL  OF  PUBLIC  SEEVICU  PROPERTIES 

either  event  the  replacement  may  be  at  a  greater  or  less  cost  than 
the  original  cost,  with,  therefore,  a  corresponding  increase  or  decrease 
of  capital  invested.  The  expenditure  for  replacement  is  amortization 
only  to  the  extent  that  it  retires  capital  already  invested. 

Perhaps,  in  referring  to  the  worn-out  part,  the  term  "retirement" 
would  be  more  applicable.  In  the  sense  in  which  "replacement"  is 
used  throughout  this  paper,  except  when  otherwise  explained,  it  is 
that  part  of  the  new  investment  in  permanent  construction  which  is 
equal  to  the  capital  theretofore  invested  in  the  parts  which  are  dis- 
carded and  replaced.  Expenditures  for  new  parts  of  a  plant,  which 
take  the  place  of  old  parts  which  are  retired  for  any  cause,  should 
be  charged  to  replacement  only  to  the  extent  of  capital  thus  retired. 
Any  excess  of  the  expenditure  for  replacement  over  the  cost  of  the 
discarded  part  of  a  plant  should  be  treated  as  an  addition  to,  and  any 
less  cost  as  a  deduction  from,  the  invested  capital.  The  term, 
"replacement,"  used  in  the  sense  of  retirement  of  invested  capital, 
deals  with  the  cost  of  the  replaced  part  and  not  with  that  of  the  new 
equivalent  installation.  Theoretically,  the  amount  which  should  go 
into  an  amortization  fund  should  be  estimated  on  the  basis  of  invested 
capital  or  cost,  and  actual  replacement  should  be  made  up  out  of  this 
fund  as  far  as  the  same  may  prove  adequate. 

Eetuming  again  to  the  case  of  the  supposed  valuation  by  a  seller 
and  by  a  purchaser  of  a  plant  with  a  20-year  useful  life,  at  the  end  of 
a  10-year  period;  there  is  no  need  of  assuming  that  an  amortization 
fund  has  actually  been  created.  In  the  case  of  both  the  original 
owner  and  a  purchaser,  the  amortization  annuity,  instead  of  being 
actually  placed  in  funds,  may  be  otherwise  invested. 

When  the  owner  of  a  plant  which  is  yielding  4%  per  annum  and 
nothing  for  amortization,  sets  apart,  out  of  the  4%,  an  annual 
amount,  also  bearing  interest  at  4%,  to  meet  its  replacement  at  the 
end  of  the  plant's  useful  life,  he  has  invested  not  only  the  original 
cost  of  the  plant,  no  part  of  which  comes  back  to  him  in  the  annual 
4%  return,  but  also  a  gradually  increasing  sum  which  in  the  life  of 
the  plant  will  become  adequate  to  replace  it.  At  the  end  of  the 
plant's  usefulness,  after  replacing  it  with  a  new  one,  the  total  invest- 
ment will  be  doubled  without  any  increase  of  earning  capacity,  and 
the  owner  will  have  in  effect  lost  his  original  investment. 

It  follows  from  this  that  a  return  of  4%  per  annum,  without  any- 


THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES  777 

tiling  for  amortization,  on  an  investment  in  a  perishable  plant,  when 
money  is  worth  4%,  is  inadequate.  The  excess  of  earnings  over 
expenditures  must  be  at  least  equal  to  the  current  interest  rate  on 
safe  money  investments  plus  an  increment  depending  on  the  useful 
life  of  the  plant.  This  increment  must  be  such  that,  within  the  life 
of  the  plant,  it  will  return  to  the  owner  his  original  investment. 

Had  the  owner  borrowed  money  for  the  construction  of  the  plant, 
and  were  he  paying  interest  on  the  borrowed  money  at  4%,  this  fact 
would  be  self-evident.  The  4%  earnings  would  then  be  required  to 
meet  interest  payments,  and,  at  the  time  when  his  plant  has  reached 
the  end  of  its  life  and  must  be  replaced  with  a  new  one,  he  would  find 
himself,  not  only  in  debt  for  the  original  plant,  but  would  have  to 
duplicate  the  indebtedness  for  the  replacement. 

The  amortization  increment  is  ordinarily  expected  to  appear  in  the 
earnings  as  that  sum  which,  at  compound  interest  during  the  life  of 
the  plant,  will  be  adequate  to  retire  the  original  investment. 

To  illustrate  these  points  further,  let  it  be  supposed  that  owner- 
ship is  represented  by  capital  stock  of  a  corporation.  If  the  plant 
owned  by  the  corporation  earns  just  enough  to  net  4%  without  any 
allowance  for  amortization,  the  stock  which  at  the  outset  was  worth 
100%  will  gradually  decrease  in  value  until,  at  the  end  of  the  plant's 
usefulness,  it  will  be  worth  nothing. 

The  situation  is  quite  different  when  the  earnings  net  4%  plus 
an  annual  amortization  increment.  In  this  case,  the  stockholder 
receives  4%  each  year,  and  the  amortization  fund  grows  as  the  plant 
depreciates  in  value.  The  stock  remains  at  par  from  the  beginning 
to  the  end  of  the  plant's  usefulness,  and  the  money  in  the  fund  at 
the  end  of  the  period  is  available  either  for  distribution  to  the  stock- 
holders, being  a  return  of  the  money  advanced  by  them,  or  for  rein- 
vestment in  a  new  plant  to  replace  the  original  one. 

Should  a  sale  be  made  at  any  time  while  the  plant  is  in  service,  the 
valuation  of  the  plant  would  be  made,  as  already  explained,  with  due 
allowance  for  its  depreciation,  and,  this  value  being  recognized  by  a 
purchaser  and  the  price  paid,  there  would  again  be  100%  available 
for  distribution  to  the  stockholders,  the  deficiency  of  the  selling  price 
being  made  up  by  the  accumulation  in  the  amortization  fund. 

In  the  case  of  inadequate  earnings,  the  valuation  of  the  plant  by  a 
purchaser  would  be  at  all  times  less  than  the  value  determined  by 


778  THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES 

deducting  depreciation;  in  the  case  of  adequate  earnings  the  valuation 
would  be,  as  already  explained,  capital  invested  (or  the  replacement 
cost)  less  depreciation.  Yet,  in  either  case,  amortization  being  com- 
puted in  the  ordinary  way  for  the  full  expectancy  of  the  plant,  the 
only  fair  valuation  for  rate-fixing  purposes,  in  a  spirit  of  fairness  to 
both  owner  and  rate-payer,  would  be  a  valuation  at  par  without  any 
deduction  for  depreciation. 

Theoretically,  then,  a  part  of  the  earnings  each  year  should  be 
placed  in  an  amortization  fund  as  a  repayment  of  capital  invested, 
and  this  may  be  used  for  the  replacement  of  the  plant  when  it  has 
reached  the  end  of  its  life. 

The  accumulation  of  an  amortization  fund  to  be  thus  used,  how- 
ever, while  theoretically  sound  policy,  is  a  measure  not  always  adopted 
in  actual  practice,  particularly  when  the  properties  owned  are  of  a 
complex  character — when  they  are  made  up  of  numerous  parts  of 
various  periods  of  probable  usefulness.  Municipalities,  State,  and 
National  Governments,  do  not  set  apart  funds  for  the  replacement  of 
worn-out  or  antiquated  buildings,  parts  of  wa.ter-works,  street  pave- 
ments, sewers,  and  the  like,  until  occasion  arises.  They  do  not  main- 
tain funds  at  interest  out  of  which  to  reconstruct  their  public  works. 
The  sinking  fund  required  to  retire  bonds  which  may  have  been  issued 
to  construct  these  works  originally  must  not  be  confounded  with  a 
replacement  fund.  The  one  may  be  necessary  to  pay  for  the  works  in  the 
first  instance,  the  other  to  maintain  them  for  all  time.  The  annual 
contribution  to  the  sinking  fund  is  a  partial  payment  for  the  original 
work.  The  contribution  to  a  replacement  fund,  in  the  case  of  a  plant 
free  from  debt  which  is  to  serve  without  time  limit,  is  for  the  purpose 
of  perpetuating  the  work,  because  in  that  case  the  replacement  fund, 
as  far  as  it  will  go,  or  as  far  as  it  is  required,  will  be  used  for  making 
replacements. 

Though  it  may  be  difficult  to  make  satisfactory  forecasts  with 
reference  to  necessary  reinvestments  to  replace  discarded  parts  of  a 
plant,  the  requirements  for  amortization,  being  based  on  cost,  are 
usually  readily  determinable  with   some  degree  of  precision. 

Thus  far,  the  plant  considered  is  assumed  to  have  been  constructed 
and  put  into  use  all  at  once,  and  is  of  such  a  character  that  all  its 
parts  have  the  same  life.     The  same  principles  will  apply  when  a  plant 


THE  APPRAISAL  OF  PUBLIC   SERVICE  PROPERTIES  779 

is   made   up    of   many   elements    or   parts   having   various   periods    of  , 
usefulness. 

It  is  again  possible  to  determine  for  each  part  the  amortization 
fund  or  the  replacement  fund  annuity,  and  from  the  annuities  thus 
determined  to  estimate  vi^hat  the  minimum  earnings  should  be  to 
prevent  loss. 

The  following  problem  presents  itself:  In  the  case  of  a  plant  of 
gradual  development,  but  of  full  growth  and  mature  age,  the  useful 
life  of  all  the  parts  of  which  is  n  years,  it  is  desired  to  know  what 
amount  is  in  the  amortization  fund  at  any  time,  that  fund  being 
assumed  to  receive  such  an  increment  at  the  end  of  each  year  that, 
during  the  life  of  the  several  parts  of  the  plant,  this  annuity,  with 
interest,  will  amount  to  the  original  cost  of  these  parts. 

Being  composed  of  a  large  number  of  elements — each  year  having 
added  new  ones — the  addition  to  it  per  year  will  be  taken  at  one-nth 
of  the  total  plant  as  it  stands  at  the  end  of  the  nth  year. 

For  each  dollar  invested  in  the  first  year,  there  will  be  $1  invested 
in  each  succeeding  year,  and  for  each  dollar  thus  invested  there  will 
be  n  dollars  of  total  investment. 

Let  i  represent  the  rate  of  interest  per  year,  and  a  represent  the 
annual  contribution  to  the  amortization  fund  for  each  dollar  invested. 

Assume  this  to  be  available  at  the  end  of  each  year. 

Then  na  will  be,  after  n  years,  the  annual  contribution  to  the 
amortization  fund  for  each  dollar  invested. 

Let  m  represent  any  number  of  years  greater  than  n. 

During  the  first  n  years,  after  beginning  the  construction  of  the 
plant,  there  will  be  no  replacements,  and  the  amortization  fund  con- 
tinues to  grow.  At  the  end  of  the  nth  year  the  replacement  require- 
ment, assuming  permanency  in  character  and  cost,  will  be  $1  for  each 
dollar  of  annual  investment,  and  this  replacement  requirement  will 
continue  at  this  rate  thereafter. 

At  the  end  of  the  nth  year  the  amortization  fund  will  contain: 

For  each  dollar  invested  the  first  year: 


n-l  ,1  nn  _L  o\     ra-2 


a 


/lUU  -|-  l\  ■•'  '    ,         /lUU  -t-  i\   "-* 

(^loor  )     +  «  (-IccT )      +  ■  •  + « ^^"^- 


100  a  r  /lOO  +  h 


iUU  a  r  /lUU  -\-  i\"        ^  -I 


dollars 


780  THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES 

For  each  dollar  iuvested  the  second  year  : 

lOO  +  iv  "=    ,       /100  +  iN  '*-=* 


n"To(r)    +<^oo-)     +•■••+«  d«"-- 

100  ar  /100  +  K  "-^        -.n  ^  n 
Or,  -^[  (-f^)        -  l]  dollars 


For  each  dollar  invested  the  nth  year:  a  dollars 

Less  the  $1  replacement  requirement  at  the  end  of  the  nth  year. 

Therefore,  the  total  amount  in  the  sinking  fund  at  the  end  of  the 

nth  year,   after  deducting   the   $1   replacement  requirement   of  that 

year: 

100  a  r  /lOO  +  ix  **         ^        /lOO  +  i\  "-^ 

'^^-==-^"LV^oo~)    -^  +  ^-100^7       -1+.... 

^      100  J 

100  a  UOO  r  /lOO  +  i\  "  +  i      100  +  i-i  >        ^ 

^^--^\-[K-wo-)      io^J-M-1 

_  10  000  a  r  /lOO  +  i\  **  +  ^       100  +  i        nin 
'^'"""^^       Lv     100    )  100  100  J  ~ 

There  will  be  in  the  sinking  fund  for  each  dollar  invested : 

At  the  end  of  the  (n  +  l)st  year  : 

/lOO  +  i\     ,  . 

At  the  end  of  (n  +  2)d  year  :  * 

'100  +  i\\    ,  ^     /lOO  +  ^ 


S„    .    o   =:    (S„ 


■'n  +  2 


/lUU  -t-  *\        ,     ,  ,       /iUU  +  ^\ 


At  the  end  of  the  (n  +  3)d  year  : 

„  Q     /lOO  +  i^^   ,    ^  ,100  +  ^2 

.    ,  ,      /lOO  +  i\ 

+  („a  — 1)   (^     ^^^    j   +na  — 1. 

And  so  on,  and  at  the  end  of  the  mth  year  : 

"  V     100    /  ^  ^  V     100    / 

,      /100  +  t\    ™-«-2 
+  (««  — 1)   (-^^^)  + +  na—  1. 

Substituting  the  value  of  S^  and  summarizing  the  series: 


THE  APPEAISAL  OP  PUBLIC  SERVICE  PEOPEETIES 


781 


«»   = 


10  000  a  r  /lOO  +  K  ™  +  ^ 


L  V    100    )  ~  \     100     / 


n  +  1 


100 
ni    /lOO  +  iN  "'-"- 


100 


/lOO  +  ix  "^-"-j 

\    100  7       -I 

100  r(100'^+i)™-'»  — 
i     L  100™-" 


/lOOjfi^ 

V  100 


100" 


—J  (na 


!)• 


In  this  form  the  formula  is  convenient  for  use,  being  applicable 
to  any  value  of  n  and  any  rate  of  interest. 

For  the  interest  rate  of  4%  per  annum,  that  is,  for  i  ^  4,  the 
formula  becomes: 


S„ 


a 


0.0016 


For  m 


[1.04'"  +  1 


n  +  1 


1.04"' 


+ 


0.04 
n,  this  formula  becomes  : 


0.04  n  (1.04)™-"]  —  1.04" 

L 
(na  —  1). 


(1.04"  +  '  —  1.04  —  0.04  n)  —  1. 


0.0016 

Applying  the  foregoing  formulas  to  various  periods  of  life,  but 
adhering  to  an  interest  rate  of  4%,  the  following  amounts  in  amorti- 
zation funds  at  various  times  are  to  be  noted: 

For  a  plant  of  full  grov^th,  all  parts  of  which  have  a  useful  life  of 
5  years :  n  =  5,  a  =  0.1846,  and  the  total  invested  capital  is  equal 
to  five  times  the  annual  investment: 


Years. 

Amount  in  amortization 

fund  for  each  $1 
of  annual  investment. 

Amount  in  amortization 

fund  in  percentage 

of  total    mvestment. 

At  the  end  of  5 

$1.92 
1.98 
1.92 
1.92 

as  4 

'•     "       "     "    10 

38  (i 

"     "       "    "   15 

as  4 

li       11           11       i;     on 

88  4 

'For  a  plant  of  full  grovsrth,  all  parts  of  which  have  a  useful  life 
of  10  years:  ri  =  10,  a  =  0.08329,  and  the  total  invested  capital  is 
equal  to  ten  times  the  annual  investment: 


Years. 

Amount  in  amortization 

fund  for  each  $1 
of  annual  investment. 

Amount  in  amortization 

fund  in  percentage 

of  total  investment. 

At  the  end  of  10 

$4.17 
4.18 
4.18 

4!i8 

41  7 

"     "      "      "15 

41  8 

"     "      "      "20 

41.8 

"     "      "      "80 

"     "      "      "40 

41  8 

"     "      "      "   80 

782  THE  APPKAISAL  OF  PUBLIC  SERVICE  PEOPERTIES 

For  a  plant,  all  parts  of  which  ha,ve  a  useful  life  of  20  years: 
n  =  20,  a  =  0.3358,  and  the  total  invested  capital  is  equal  to  twenty 
times  the  annual  investment : 


Years. 

Amount  in  amortization 

fund  for  each  $1 
of  annual  investment. 

Amount  in  amortization 

fund  in  percentage 

of  total  investment. 

At  the  end  of  20  

88.^:1 

8.20 
8.19 
S.iil 

41.1 

'•     '•       "     "    30 

41.0 

"     '•       '•     •■    40 

41.0 

"     '•       "     '•    80 

41.1 

For  a  plant  of  full  growth,  all  parts  of  which  have  a  useful  life 
of  40  years:  n  =  40,  a  =  0.01052,  and  the  total  invested  capital  is 
equal  to  forty  times  the  annual  investment: 


Years. 

Amount  in  amortization 

fund  for  each  $1 
of  annual  investment. 

Amount  in  amortization 
fund  in  percentage 
of  total  investment. 

At  the  end  of  40 

$14.47 
14.40 
14.43 

86.1 

"    "      "     "   60 

36.0 

ti    bi      fc4     ii    tjfh 

36.1 

In  the  foregoing  mathematical  analysis,  a  plant  has  been  assumed 
which  has  already  reached  an  age  exceeding  the  useful  life  of  its 
parts,  and  has  reached  its  full  growth. 

The  same  formulas  will  apply  in  the  case  of  any  plant  of  mature 
age  and  gradual  growth,  even  when  the  growth  is  still  being  extended, 
because  in  this  special  case  the  plant  may  be  regarded  as  made  up 
of  two  groups  of  parts,  one  embracing  all  those  having  an  age  of  n 
years  or  less,  and  the  other  those  parts  which  are  more  than  n  years 
of  age,  and  for  both  these  groups  the  formulas  apply. 

It  is  noteworthy,  in  the  assumed  case  of  a  plant  of  full  growth 
made  up  of  numerous  parts,  that  the  amortization  fund  should  bear 
a  nearly  uniform  relation  to  capital  invested,  whatever  the  life  of  the 
plant  may  be.  For  such  a  plant  constructed  progressively,  all  parts 
of  which  have  a  useful  life  of  5  years,  the  amortization  fund  will,  at 
any  time  after  5  years,  contain  an  amount  equal  to  about  38%  of  the 
cost;  for  a  similar  plant  with  a  20-year  life,  41%;  and  for  a  similar 
plant  with  a  40-year  life,  36  per  cent. 

The  accumulation,  therefore,  in  amortization  funds,  under  certain 
hypothetical   conditions,   when   plants   are  of  progressive  growth   and 


THE  APPRAISAL  OF  PUBLIC   SERVICE  PROPERTIES  783 

mature  age  and  are  composed  of  numerous  parts,  at  4%  interest, 
amounts  to  about  40%  of  the  invested  capital.  In  reality,  however, 
there  is  never  absolute  agreement  between  the  actual  useful  life  of 
every  part  of  the  plant  and  its  expectancy.  The  formulas  are  never 
strictly  applicable.  The  requirements  for  replacement  may  begin  long 
before  the  expectancy  is  attained,  and  if  met  from  the  amortization 
fund  will  check  its  growth. 

The  non-existence  of  a  fund  in  the  full  amount  indicated  by 
mathematical  and  theoretical  considerations,  therefore,  does  not 
always  show  that  it  has  been  distributed  as  profit,  nor  yet  that 
there  has  been  an  intentional  waiver  of  the  right  to  have  the  earnings 
cover  a  fair  amortization  allowance. 

Furthermore,  if  the  annual  amortization  increment  is  immediately 
applied  in  repayment  of  invested  capital,  the  same  no  longer  bears 
interest.  Treated  as  an  annuity,  interest  may  be  compounded  only 
as  long  as  the  fund  remains  practically  in  escrow  for  its  intended 
purpose,  that  is,  for  complete  retirement  at  the  end  of  the  useful  life 
of  the  plant.  Interest  ceases  to  accumulate  the  moment  the  fund  is 
applied  to  retire  the  investment  in  whole  or  in  part.  Consequently,  if 
the  amortization  be  determined  from  amortization  tables  based  on 
expectancy,  and  be  covered  by  the  earnings  from  year  to  year,  even 
though  the  amortization  increment  as  earned  be  reinvested  in  the 
property,  it  cannot  rightfully  be  classed  as  a  repayment  of  invested 
capital  until  the  end  of  the  period  of  expectancy.  If  so  applied  at 
any  earlier  date,  a  new  amortization  annuity,  based  on  the  remaining 
life,  must  be  computed. 

If,  nevertheless,  the  amortization  annuity  as  originally  determined 
be  deducted  from  the  investment  from  year  to  year,  the  result  will  be 
incomplete  amortization.  In  the  case  of  a  40-year  life,  the  amortiza- 
tion of  the  invested  capital  would  be  only  $42.08  of  each  $100,  and 
there  would  still  remain  $57.92  to  be  made  good. 

These  facts  make  clear  the  point  which  is  to  be  emphasized,  that, 
whenever  amortization  is  based  on  annuities  bearing  compound 
interest,  the  appraisal  for  rate-fixing  purposes  must  be  of  the  entire 
investment  without  reduction  for  depreciation. 

The  foregoing  mathematical  demonstration  that  the  accumulation 
in  an  amortization  fund  for  a  plant  of  mature  age  should  amount  to 


784  THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES 

a  considerable  sum,  confirms  a  conclusion  which  can  be  reached  in  a 
more  direct  way. 

In  the  assumed  case  of  a  plant  which  has  a  life  of  n  years,  and 
of  which  one-nth  has  been  constructed  each  year,  after  n  years  there 
will  have  to  be  replaced  one-nth  thereof  each  year.  Because  the 
annual  investment  in  the  installation  has  been  uniform,  there  will  be, 
for  each  dollar  invested  per  year,  a  total  investment  of  n  dollaxs. 

The  annual  replacement  after  n  years,  for  each  dollar  annually 

invested,  will  be  $1.    If  now  the  annuity  to  replace  the  several  parts 

of  the  plant  in  n  years  is  a  for  each  dollar  of  the  annual  investment, 

then  after  n  years,  the  annual  amount  received  as  annuity  wiU  be  a  n, 

and  this  will  fall   short   of  meeting  the   actual   expenditure  by   an 

amount  expressed  by   (1   —  an)   which,  at  4%   per  annum,  is  the 

100  (]  —  a  n)        - 
interest  on dollars;  or,  expressed  in  percentage  of  the 

.     lOO''  (1  —  a «)  ,   ,  ,  .  .      ,       , 

cost,  is per  cent,  of  the  total  investment  m  the  plant. 

4  n 

For  a  plant  not  subject  to  further  growth,  with  a  uniform  useful 
life  of  all  its  parts,  and  constructed  progressively,  there  will  be  needed, 
at  4%  interest,  to  supplement  the  deficient  amortization  annuity: 

When  the  iiseful  life  is  6  years: 

100*  (1  —  0.923)  ^    , 

T ^T =  38.5%  of  the  total  replacement  cost. 

When  the  useful  life  is  10  years: 

100*  (1  —  0.8329) 

7q =  41.3%  of  the  total  replacement  cost. 

When  the  useful  life  is  20  years: 

100*  (1  —  0.6716) 

^7j =  42.3%  of  the  total  replacement  cost. 

When  the  useful  life  is  40  years: 

100*  (1  —  0.4208) 

— ==  36.2%  of  the  total  replacement  cost. 

These  figures  are  in  substantial  agreement  with  those  resulting 
from  the  first  analysis.  They  show  that,  in  order  to  make  an  annual 
allowance,  estimated  by  tlie  annuity  amortization  fund  method,  ade- 
quate to  keep  a  plant,  of  the  kind  assumed,  in  good  condition,  there 
must  be  allowed  to  accumulate  and  be  kept  always  on  hand  a  fund  at 


THE  APPHAISAL  OF  PUBLIC  SERVICE  PEOPEETIES  785 

4%  interest  which,  for  expectancies  of  from  5  to  40  years,  is  some- 
where near  40%  of  the  replacement  cost  of  the  plant. 

Some  such  amount,  depending  on  the  expectancy,  represents  the 
accumulation  of  the  annuities  during  that  period  of  the  plant's  life 
during  which  no  replacements  were  necessary.  If  the  annual  allow- 
ance for  maintenance  has  been  in  the  past  based  on  the  requirements  of 
operation  and-repair  without  surplus  to  meet  future  replacements,  then 
the  current  allowance  for  amortization  or  replacement  should  not  be 
determined  by  the  amortization  fund  annuity  method,  but  should  be 
otherwise  determined,  as  shown  subsequently. 

When,  in  other  words,  opportunity  has  not  been  given  to  accumu- 
late the  40%  (approximately),  for  ordinary  periods  of  useful  life  of 
perishable  properties,  of  the  invested  capital,  then  any  amount  esti- 
mated from  amortization  tables  on  the  original  full  period  of  useful 
life  will  fall  short  of  the  real  replacement  requirement.  To  illustrate 
this  point,  let  it  be  assumed  that  a  conduit,  such  as  a  cast-iron  pipe, 
used  for  any  purpose,  has  a  length  of  40  miles.  Let  it  be  also 
assmned  that  the  pipe  is  not  being  further  extended,  that  the  ex- 
pectancy of  this  pipe  is  40  years,  and  that  it  was  constructed  progres- 
sively, 1  mile  each  year.  It  took  40  years  to  install  the  pipe,  and  at 
the  end  of  this  time  the  first  mile  of  pipe  laid  was  ready  for  replace- 
ment— it  had  served  its  time.  Each  year  thereafter,  1  mile  of  pipe  has 
to  be  replaced,  and  the  replacement  at  this  rate  will  continue  indefi- 
nitely. The  annual  replacement  expenditure  during  the  first  40  years 
is  nothing,  but,  thereafter,  it  is  the  cost  of  installing  1  mile  of  pipe. 
If  prices  of  labor  and  material  have  remained  constant,  and  if  condi- 
tions have  otherwise  remained  as  they  were  when  the  first  mile  of 
pipe  was  laid,  then  the  annual  replacement  expenditure  will  be  one- 
fortieth  of  the  total  amount  invested  in  the  pipe  line. 

Provision  for  this  replacement  must  be  made  if  the  pipe  is  to 
continue  in  service.  If,  now,  the  extension  of  the  pipe  progresses 
beyond  the  40-year  period  at  the  same  rate,  before  assumed,  of  1  mile 
per  year,  there  will  be  no  changes  in  the  annual  replacement  require- 
ment during  a  second  period  of  40  years,  but  at  the  end  of  this  second 
period — at  the  end  of  80  years — there  will  be  80  miles  of  pipe  in 
service,  and  thereafter  during  the  third  40-year  period  there  will  have 
to  be  replaced  annually  2  miles  of  pipe,  or  one-fortieth  of  SO  miles,  or 
twice  the  amount  of  pipe  extension  per  annum. 


786  THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES 

It  is  possible,  by  such  analysis,  when  a  plant  is  of  progressive 
growth  and  has  attained  an  age  exceeding  the  life  of  its  perishable 
parts,  to  prescribe  a  rule  for  determining  the  replacement  require- 
ment; but  it  must  be  remembered  that  a  rule  thus  determined  can  be 
strictly  correct  only  for  the  hypothetical  case  of  service  in  exact  con- 
formity with  the  assumed  probable  life,  and  that  a  rule  thus  deter- 
mined may  require  some  modification,  as  hereinafter  explained. 

For  each  group  of  parts  having  the  same  length  of  life,  there  is  to 
be  determined:  first,  the  average  annual  capital  invested,  using,  how- 
ever, replacement  cost  instead  of  the  actual  investment;  and  second, 
the  full  number  of  times  that  the  age  of  the  plant  is  greater  than  the 
useful  life  of  the  particular  group  of  parts  under  consideration.  The 
replacement  requirement  (for  the  hypothetical  case,  in  which  actual 
service  conforms  throughout  with  the  assumed  probable  life)  is  then 
ascertained  by  multiplication. 

A  pipe  line  may  again  serve  as  an  illustration :  Suppose  it  is 
desired  to  know  the  replacement  requirement  for  a  pipe  line  300  miles 
long,  which  has  been  extended  2  miles  each  year,  the  age  of  the  oldest 
portion  of  which,  therefore,  is  150  years. 

The  life  of  the  pipe  being  taken  at  40  years,  the  full  number  of 
times  this  is  contained  in  150  years  is  three.  The  annual  replacement 
requirement  will  be  three  times  two,  or  6  miles  of  pipe. 

The  6  miles  of  pipe  requiring  replacement  were  constructed  40 
years  ago,  and  the  conditions  under  which  this  was  done  may  have 
been  materially  at  variance  with  those  prevailing  at  the  time  of 
their  replacement.  Consequently,  in  the  determination  of  the  replace- 
ment requirement,  expressed  in  dollars  instead  of  in  miles  of  pipe, 
the  replacement  cost  of  the  system  and  not  the  original  cost  of  capital 
invested  should  be  taken  into  account.  Expressed  as  a  percentage  of 
the  total  length  of  pipe  in  service,  or  of  the  total  cost  of  replacing  the 
entire  pipe  line,  this  would  be  2  per  cent. 

,«.,  By  the  annuity  method  of  computation,  in  the  selected  illustration, 
the  allowance  for  replacement  would  be  1.052%  of  the  cost  of  the 
system,  which  is  barely  more  than  one-half  of  the  actual  requirement, 
and  this  allowance,  as  already  explained,  would  only  then  be  justified 
if  amortization  had  covered  the  entire  period  in  the  life  of  each  part 
of  the  pipe  during  which  there  was  no  expenditure  for  replacements. 


THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES  787 

SO  that  the  inadequate  annual  allowance  could  be  supplemented  by 
the  earnings  of  an  accumulated  amortization  fund. 

In  a  plant  which  is  made  up  of  a  multiplicity  of  parts  of  various 
periods  of  usefulness,  those  which  have  the  same  expectancy  should, 
as  before  stated,  be  grouped  together.  For  each  group,  the  replace- 
ment requirement  can  then  be  estimated  separately,  and  from  the 
several  amounts  thus  ascertained  the  total  requirement  is  determined. 

The  rule  previously  laid  down  for  a  hypothetical  case  is  not 
strictly  applicable  under  the  conditions  as  they  actually  present  them- 
selves. There  can  be  no  absolute  conformity  between  the  assumed 
period  of  usefulness  of  any  part  of  a  plant  and  the  time  during  which 
it  actually  proves  useful. 

The  probable  useful  life  or  expectancy  is  merely  the  average  life, 
which  is  often  not  reached  and  is  just  as  often  exceeded.  Thtis, 
again  referring  to  the  pipe  line,  it  is  to  be  assumed  that  while  some 
of  it  may  serve  beyond  the  average  period  of  usefulness  of  such  pipe, 
other  parts  thereof,  from  one  cause  or  another,  will  require  replace- 
ment early  in  its  life.  Consequently,  any  rule  such  as  that  previously 
laid  down,  which  indicates  a  uniform  replacement  requirement  in  suc- 
cessive periods,  with  a  sudden  rise  in  the  requirement  at  the  begin- 
ning of  each  new  period,  if  the  plant  be  one  that  is  steadily  growing, 
will  require  some  modification. 

The  simplest  modification  of  the  foregoing  rule  is  to  assume 
gradual  changes  in  the  annual  replacement  requirement  as  the  age  of 
the  plant  increases,  instead  of  the  sudden  changes,  and  then  to  call 
this  requirement  at  all  times  inversely  proportional  to  the  useful  life 
of  any  group  of  parts.  This  is  sometimes  referred  to  as  the  "straight- 
line"  method.  It  might  with  equal  proprie*ty  be  called  the  direct 
percentage  method,  as  the  inverse  ratio  is  usually  expressed  in 
percentage. 

Under  this  direct  percentage  method,  there  would  be  allowed  2.5% 
per  annum  of  the  replacement  cost  of  all  parts  of  a  plant  having  a 
40-year  life;  3.33%  per  annum  of  the  replacement  cost  of  all  parts 
having  a  30-yea.r  life;  5%  per  annum  of  the  replacement  cost  of  all 
jparts  having  a  20-year  life,   and  so  on. 

This  method,  applied  to  the  hypothetical  case  of  a  pipe  line,  con- 
structed and  extended  1  mile  per  year,  and  each  mile  thereof  having 
a  useful  life  of  exactly  40  years,  would,  at  the  end  of  the  fortieth 


788  ^THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES 

year,  make  the  replacement  requirement  2.5%  per  annum,  or  1  mile 
of  pipe.  At  the  end  of  the  sixtieth  year,  the  requirement  thus  deter- 
mined would  be  2.5%  of  the  60  miles  of  pipe  then  in  service,  or  1.5 
miles  of  pipe.  This  would  be  50%  in  excess  of  the  amount  actually 
replaced,  which  at  that  time  would  be  only  1  mile.  This  would  also 
apply  for  any  time  before  the  pipe  first  laid  has  reached  the  limit  of 
its  usefulness,  as  at  20  years.  In  the  assumed  case  there  is  no 
replacement  requirement  at  20  years;  yet  the  straight  percentage 
method  indicates  2.5%  of  20  miles  of  pipe,  or  0.5  miles  of  pipe.  It 
follows  from  this  illustration  that  the  straight-line,  or  direct  per- 
centage, method,  applied  to  an  estimated  total  cost  of  replacement, 
would  give  results  somewhat  too  high. 

By  further  analysis  of  this  problem,  the  following  formulas  have 
resulted,  which  are  free  from  this  objection  and  fulfill  every  ordinary 
requirement.  In  devising  these  formulas,  the  fact  was  taken  into 
account  that  there  may  be  some  replacement  requirement  in  the  early 
years  of  a  plant's  life,  and  that  this  requirement  gradually  increases. 
These  formulas  apply  strictly  only  to  plants  which  have  been  developed 
gradually  and  are  being  extended  at  a  uniform  annual  rate. 

Using   the   notation   already   introduced,    and   designating   with   E 

the  total  cost   of   replacing  the   group  of   items,   the  probable   useful 

life  of  which,  when  new,  was  n  years,  and  with  e  =  the  average  annual 

cost  of  extensions,  the  formulas  are: 

me  B 

Tor  m  less  than  n:  r  =  x — ?  oi"  =  t: — • 

2  n  2  n 

He 

Jb  or  m  greater  than  n:  r  =  —  —  ^ . 

For  very  large  values  of  m  in  relation  to  n  (n  being  the  years  of 

probable  usefulness),  the  value  of  this  expression  approaches  —,  which 

is   the    mathematical    equivalent   of   the   straight-line,    or   direct   per- 
centage, method. 

However  desirable  it  might  otherwise  appear  to  introduce  a  method 
of  computing  the  replacement  requirement  by  recourse  to  amortization 
tables,  to  do  this  equitably,  in  the  case  of  a  complex  plant,  is  usually 
difficult,  if  past  earnings  have  been  inadequate  to  supply  the  proper 
amortization  increment.     In  such  cases  the  use  of  some  formula,  as 


THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES  789 

above   noted,   for  probable   replacement  requirement   is   to   be   recom- 
mended. 

This  method  is  strictly  equitable  from  the  standpoints  of  both  the 
owner  and  the  ratepayer.  That  this  must  be  so  will  be  seen  on 
reflection. 

The  annuity  or  ordinary  method  of  retirement  may  be  regarded  as 
an  installment  method.  Under  the  replacement  method  an  exactly 
equivalent  lump  sum,  "the  amount  of  the  annuity,"  takes  the  place 
of  the  installments.  If  the  installments  are  forthcoming  as  they  are 
due,  then  the  annuity  method  is  adequate.  If  they  are  not  paid, 
then  recourse  must  be  had  to  the  lump  sum  or  replacement  method 
as  above   described. 

It  is  perfectly  reasonable,  moreover,  to  assume,  unless  there  is 
evidence  to  the  contrary,  that  the  method  of  estimating  amortization 
requirements,  which  prevails  in  any  case,  has  been  introduced  delib- 
erately. The  owner  of  the  public  service  property  may  be  perfectly 
willing  to  waive  the  annuity  payments  if  he  knows  that  what  they 
will  amount  to,  that  is,  the  actual  annual  replacement,  will  be  covered 
by  the  gross  earnings  when  the  time  comes  for  discarding  parts  of  his 
plant.  In  other  words,  he  may  be  willing  to  accept  the  amount  of  an 
annuity  in  lieu  of  the  annuity  itself;  and  the  rate-payer  may  desire 
such  an  arrangement,  because,  in  the  early  days  of  the  plant's  life, 
he  may  not  be  able  to  pay  a  sufficient  amount  for  the  service  to  cover 
the  amortization  annuity.  It  must  be  remembered,  however,  that  such 
an  arrangement  burdens  the  future  rate-payer  to  some  extent  for  the 
benefit  of  the  rate-payer  in  the  early  days  of  a  plant's  life.  This  is 
the  same  idea  as  the  one  which  prompts  some  engineers  to  add  early 
losses  to  the  valuation  as  a  part  of  that  intangible  value  which  is 
usually  called  "going  concern." 

It  follows  directly  from  the  foregoing  that  there  may  be  cases  in 
which,  even  though  it  be  found  proper  to  allow  the  full  actual  average 
annual  replacement,  the  appraisal  for  rate-fixing  purposes  should  still 
be  the  entire  investment  without  any  reduction  for  depreciation.  This 
will  be  the  case  whenever  it  can  be  shown  that  past  earnings  were 
inadequate  to  provide  an  amortization  fund. 

The  Expectancy. 
Whether   the   plan    of   making   the   annual   replacement   allowance 
conform  to  the  annual  actual  replacement  requirement,  as  determined 


790  THE  APPRAISAL  OF  PUBLIC   SERVICE  PROPERTIES 

by  formula,  be  followed,  or  whether  either  of  the  other  two  methods 
be  adopted  (the  direct  percentage  method  or  the  annuity  method),  due 
regard  should  be  had,  in  fixing  the  expectancy,  to  the  circumstances 
under  which  the  plant  is  being  operated  and  has  been  operated  in 
the  past. 

Such  disasters  as  the  fire  and  earthquake  of  1906,  which  suddenly 
put  out  of  service  large  portions  of  the  public  service  plants  of  San 
Francisco,  which  would  otherwise  have  remained  useful,  may  properly 
be  taken  into  account,  as  noted  hereafter,  in  estimating  the  probable 
useful  life  of  any  part  of  a  plant. 

It  must  not  be  expected,  however,  that  the  replacement  increment, 
by  whatever  method  determined,  will  in  any  year  exactly  meet  the 
actual  replacement  requirement  of  that  year.  When  some  unusually 
costly  part  of  the  plant  goes  out  of  use  and  must  be  replaced,  a  single 
item  of  the  replacement  expense  may  greatly  exceed  the  annual  replace- 
ment allowance,  while,  on  the  other  hand,  whole  series  of  years  are  to 
be  expected  in  which  the  actual  expenditure  for  replacement  will  fall 
below  the  allowance  for  replacement. 

In  the  long  run,  if  all  assumptions  have  been  properly  made,  there 
should  be  neither  gain  nor  loss  resulting  from  the  allowance  for 
replacement. 

Before  leaving  this  subject,  it  may  be  well  to  illustrate  the  fact 
that,  when  the  age  of  a  growing  plant  is  many  times  greater  than  the 
useful  life  of  a  class  of  parts,  the  error  made  in  applying  the  direct 
percentage  method  of  computing  replacement  requirement  will  be 
small,  and  may  ordinarily  be  disregarded. 

In  a  plant  which  is  63  years  old,  for  example,  and  has  been 
extended  at  a  uniform  rate,  those  parts  which  have  a  useful  life  of 
5  years  should,  according  to  the  correct  formula,  be  19.2%  per  annum, 
while,  on  the  assumption  that  all  the  parts  having  a  5-year  life  have 
been  replaced,  or  have  been  put  in  new  at  a  uniform  rate  during  the 
preceding  5  years,  the  replacement  requirement  would  be  figured  at 
20  per  cent. 

Absolute  accuracy  cannot  be  hoped  for,  whatever  the  method  of 
calculation,  because  the  premises  assumed  as  the  basis  for  formulas  are 
never  exactly  realized.  Generally,  however,  under  consideration  of  all 
circumstances,  a  reasonable  approximation,  either  by  the  direct  per- 
centage method  or  by  some  formula  similar  to  those  previously  laid 


THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES  791 

down  for  a  special  case,  can  be  made  of  the  actual,  average  annual 
replacement  requirements,  whenever  the  amortization  annuity  method 
of  retirement  does  not  prevail. 

While  the  process  of  determining  the  annual  requirement  for  re- 
placement appears  to  be  simple,  it  is,  as  previously  intimated,  made 
somewhat  difficult  and  uncertain  of  application  owing  to  the  incom- 
plete information  available,  from  which  to  estimate  the  useful  life  of  a 
plant  or  of  the  many  parts  which  make  up  the  whole.  Many  cir- 
cumstances are  to  be  taken  into  account  in  determining  useful  life, 
for  this  depends  not  only  on  deterioration  by  natural  processes  of 
decay,  or  wearing  away  by  use,  but  also  on  inadequacy  resulting  from 
growing  demand  upon  the  plant;  also  on  inadequacy  or  obsolescence 
resulting  from  changes  in  processes  of  manufacture,  or  from  the  use 
of  new  and  better  types  of  machines  and  appliances,  and  the  like; 
and  also  destruction  by  unforeseen  agencies,  such  as  fires  and  earth- 
quakes, landslides,  floods,  and  the  like.  In  these  matters,  past  ex- 
perience is  the  best  guide,  and,  as  already  stated,  should  be  given  weight 
in  some  measure  in  assigning  probable  life  to  the  parts  of  a  plant. 

In  the  case  of  gas-works,  for  example,  the  life  of  generators  is 
shortened  by  the  advance  made  in  the  art  of  gas  manufacture.  Within 
the  last  few  decades,  because  of  the  high  price  of  coal,  the  moderate 
price  of  oil,  the  local  abundance  of  oil,  and  the  introduction  of  new 
processes,  the  art  of  gas  manufacture  in  California  has  been  revolution- 
ized. Old  processes,  are,  for  the  time  being,  classed  as  obsolete,  and 
generators  and  other  parts  of  gas-works  have  gone  out  of  use, 
in  some  cases,  almost  before  their  installation  was  completed. 

Amortization  and  Annuity  Tables. 

The  following  tables  have  been  prepared  to  illustrate  certain 
principles,  and  no  attempt  has  been  made  to  give  the  figures  therein 
presented  that  degree  of  accuracy  which  is  usually  looked  for  in  amorti- 
zation tables. 

Table  7  is  derived  from  the  values  noted  in  Tables  2,  4,  and  6.  It 
is  the  result  of  a  multiplication  of  100  times  the  figures  in  the  column, 
"Remaining  Value,"  with  the  figures  in  the  next  to  the  last  column 
of  each  of  these  three  tables. 

The  information  contained  in  the  tables  is  also  presented  in  the 
curves  in  Figs.  1  and  2.     Attention  is  directed  to  the  fact,  appearing 


792 


THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES 


in  Table  7  and  ,in  Fig.  2,  that  the  amortization  increment  required 
to  retire  the  remaining  value  in  the  remaining  life  increases  from 
year  to  year. 

TABLE  1. — Amortization  and  Annuities.     5-Year  Expectancy. 
Interest  at  4  per  cent.     Annuities  applied  at  the  end  of  each  year. 


Annual  Amortization  Increment  for 
Each  Dollar  Invested  =  $0.1846. 

Annuity 

which  will 

amount  to  $1 

in  the 

remaining 

life. 

♦Amount  of 

At  the  end 
of  year. 

Amount  in 

amortization 

fund. 

Value 

remaining  in 

the  physical 

properties. 

Amount  of 
the  annuity  in 
the  remain- 
ing life. 

an  annuity  of 
$0.20  in  re- 
maining life. 

1 

$0,000 
0.185 
0.377 
0.576 
0.784 
1.000 

$1,000 
0.815 
0.623 
0.424 
0.214 
0.000 

$1,000 
0.785 
0.577 
0.376 
0.184 
0.000 

$0.1846 
0.2355 
0.8204 
0.4901 
1.000 

$1,083 
0.849 

2 

0.624 

3 

0  408 

4 

0.200 

5 

The  annuity  here  noted  is  $1  divided  by  the  expectancy. 

Appraisals  Without  Deduction  for  Depreciation. 

In  determining  the  part  of  the  investment  on  which  the  investor 
in  public  service  properties  should  be  allowed  a  reasonable  income, 
all  attendant  circumstances  must  be  duly  considered.  It  may  be  stated, 
however,  that,  apart  from  the  determination  of  the  rate  of  interest 
which  should  result  from  the  investment,  it  will  be  strictly  equitable 
and  fair  to  consider  the  public  service  corporation  as  the  agent  of 
the  State  or  municipality,  as  the  case  may  be,  and  to  determine  in  what 
situation  the  State  or  municipality  would  have  found  itseK  had  there 
been  no  intermediate  owner  or  public  service  corporation. 

Let  it  be  assumed  that  the  owner  of  a  public  service  plant  has  made 
his  investment  under  good  expert  advice,  and  that  the  plant  is  in 
every  respect  the  same  as,  or  equal  to,  what  the  people  could  have 
constructed  for  themselves.  Let  it  be  further  assumed  that  the  plant  is 
free  from  debt,  and  that  it  and  all  its  parts  have  a  probable  useful 
life  of  n  years.     The  owner  will  then  be  entitled: 

First. — To  a  reasonable  interest  on  his  investment; 
Second. — To  operating  expenses; 
Third. — To  maintenance  and  repair  expenditures; 
Fourth. — To  an  annuity  which,  in  n  years,  at  the  ordinary  rate 
of  interest,   will   amount  to  his  investment. 


THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES  793 

TABLE  2. — Amortization  and  Annuities.     10- Year  Expectancy. 


Annual  Amortization  Increment  fob 

Annuity 

which  will 

amount  to  $1 

in  the 

remaining 

Ufe. 

Each  Dollar  Invested  =  $0,838. 

*  Amount  of 

At  the  end 
of  year. 

Amount  in 

amoi'tization 

fund. 

Value 

remaining  in 

the  physical 

properties. 

Amount  of 
the  annuity  in 
the  remain- 
ing lite. 

an  annuity  of 
$0.10  in  re- 
maining life. 

1 

$0,000 
0.083 
0.170 
0.260 
0.354 
0.451 
0.5.52 
0.658 
0.767 
0.881 

■     $1,000 
0.917 
0.&30 
0.740 
0.646 
0.549 
0.448 
0.342 
0.238 
0.119 

$1,000 
0.881 
0.766 
0.658 
0.552 
0.451 
0.354 
0.260 
0.170 
0.083 

$0.08339 
0.09449 
0.10853 
0.12661 
0.15079 
0.18463 
0.23550 
0.32036 
0.49020 
1.000 

$1,201 
1  058 

2 

0  921 

8 

0  790 

4 

0  683 

5 

0  542 

6 

0  425 

7 

0  312 

8 

0  204 

9 

0.100 

10 

1.000 

0.000 

0.000 

,  *  The  annuity  here  noted  is  $1  divided  by  the  expectancy. 

TABLE  S.^Amortization  and  Annuities.     15- Year  Expectancy. 


At  the  end 

of  year. 


1 

2 

3 

4 

5 

6 

7 

8 

9 

10 

11 

12 

18 

14 

15 


Annual  Amortization  Increment  for 
Each  Dollar  Invested  =  $0.0499. 


Amount  in 

amortization 

fund. 


.000 
.050 
.102 
.156 
.212 
.270 

S31 

894 
.460 
.529 

600 
.1673 
.750 

830 
.913 
.000 


Value  Amount  of 
remaining  in  the  annuity  in 
the  physical  the  remain- 
properties,  ing  life. 


$1,000 
0.950 
0.898 
0.844 
0.788 
0.730 
0.670 
0.606 
0.540 
0.471 
0.400 
0.327 
0.250 
0.170 
0.087 
0.000 


$1,000 
0.913 
0.830 
0.750 
0.673 
0.600 
0.529 
0.460 
0.394 
0.331 
0.270 
0.212 
0.156 
0.102 
0.050 
0.000 


Annuity 

which  will 

amount  to  $1 

in  the 

remaining 

life. 


$0.04994 
0.05467 
0.06014 
0.06655 
0.07415 
0.08329 
0.09449 
0.10853 
0.12661 
0.15079 
0.18463 
0.23550 
0.32086 
0.49020 
1.000 


*  Amount  of 

an  annuity  of 

$0,066  I  in 

remaining 

life. 


$1.3-35 
1.219 
1.008 
1.002 

■  0.899 
0.800 
0.706 
0.614 
0.527 
0.442 
0.361 
0.283 
0.208 
0.136 
0.067 


*  The  annuity  here  noted  is  $1  divided  by  the  expectancy.  ' 

If  it  be  now  supposed  tha.t  the  owner  actually  received  these  amounts, 
estimated  on  a  proper  basis,  and  that  he  allows  the  annuity  to  accumu- 
late so  that  amortization  will  be  an  accomplished  fact  at  the  end  of  n 
years,  then,  as  he  has  command  of  the  amortization  fund,  he  will  have 
a  decreasing  amount  of  capital  actually  tied  up  in  the  plant.  This  de- 
creasing capital  or  remaining  value  of  the  plant  is  the  complement  of 
the  growing   amortization  fund.     This  fund   is   supposed   to   be   held 


794 


THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES 


PERCENTAGE 


3 
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THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES 


795 


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796 


THE  APPRAISAL  OF  PUBLIC   SEEVIOE  PROPERTIES 


inviolable  for  the  replacement  of  the  plant  at  the  end  of  its  life.  The 
owner  reaps  no  benefit  from  it  whatever,  beyond  holding  it  as  the 
means  for  replacing-  a  worn-out  plant. 

TABLE  4.— Amortization  and  Annuities.    20- Year  Expectancy. 


ANNUAL  Amortization  Incrembnt  for. 
Each  Dollar  Invested  =  $0.0336. 

Annuity 

which  will 

amount  to  $1 

in  the 

remaining 

life. 

♦Amount  of 

At  the  end 
of  year. 

Amount  in 

amortization 

tund. 

Value 

remaining  in 

the  physical 

properties. 

Amount  of 
the  annuity  in 
the  remain- 
ing life. 

an  annuity  of 
$0.05  in  re- 
maining life. 

$1,000 
0.929 
0.861 
t».795 
0.738 
0.672 
0.614 
0.558 
0.505 
0.453 
0.408 
0.855 
0.309 
0.265 
0.222 
0.182 
0.143 
0.105 
0.069 
0.034 
0.000 

$0.03358 
0.03614 
0.03899 
0.04220 
0.04582 
0.04994 
0.05467 
0.06014 
0.06655 
0.07415 
0.08329 
0.09449 
0.10853 
0.12661 
0.15079 
0.18463 
0.23550 
0.32036 
0.49020 
1.000 

1 

80.000 
0.034 
0.069 
0.105 
0.143 
0.182 
0.223 
0.265 
0.309 
0.355 
0.403 
0.453 
0.505 
0.558 
0.614 
0.672 
0.733 
0.796 
0.861 
0.929 
1.000 

$1,090 
0.966 
0.931 
0.895 
0.857 
0.818 
0.777 
0.735 
0.690 
0.645 
0.597 
0.547 
0.495 
0.442 
0.388 
0.328 
0.267 
0.205 
0.139 
0.071 
0.000 

$1 .489 
1.384 

2 

1.282 

3 

1.185 

4 

1.091 

5 

1.001 

6 

0.915 

7 

0.831 

8 

0.7.51 

9 

0.674 

10 

O.fiOO 

11 

0.529 

12  

0.461 

13 

0.395 

14 

0.332 

15 

0.271 

16 

0.212 

17.... 

18 

0.156 
0.102 

19 

0.050 

20 

*  The  annuity  here  noted  is  $1  divided  by  the  expectancy. 

The  value  of  the  plant  in  its  varied  stages  of  depreciation,  plus 
the  amortization  fund,  should  at  all  times  be  equal  to  the  capital 
invested  in  it.  The  owner,  if  he  gets  an  annuity,  as  here  assumed, 
is  entitled  at  all  times  to  the  interest,  not  on  a  plant  valued  at  first 
cost  or  investment  less  depreciation,  but  on  the  entire  first  cost.  Had 
he  determined,  instead  of  building  the  plant,  to  keep  his  funds  in- 
vested in  safe  securities  at  ordinary  interest  rates,  he  would,  at  the 
end  of  n  years,  have  been  in  possession  of  his  entire  capital  plus 
interest  on  the  full  amount  thereof  for  the  entire  time.  If,  under  the 
assumed  facts,  he  were  not  allowed  interest  on  the  full  amount  in- 
vested in  the  public  service  plant,  an  injustice  would  be  done. 

This  is  true  even  when  replacement  takes  the  place  of  amortization. 
The  owner  in  this  case  is  entitled  to  interest  on  the  entire  capital  in- 
vested in  the  plant,  and,  at  the  end  of  the  plant's  usefulness,  he  is  also 
entitled  to  a  return  of  the  capital  itself.    Suppose  that  a  city  constructs 


THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES 


797 


a  plant,  paying  cash  for  it,  and  collects  rates  which  will  just  yield  a 
fair  rate  of  interest  on  the  investment.  At  the  end  of  n  years  the 
plant  is  replaced  with  a  new  one  of  the  same  capacity.  As  the  city 
has  not  included  in  its  rates  theretofore  charged  an  increment  for 
amortization,  it  now  finds  itself  in  possession  of  a  new  plant  and  a  total 
investment  twice  as  great  as  the  cost  of  the  first  plant.  Applying  the 
same  principle  to  the  second  plant,  rates  should  be  doubled.  This, 
of  course,  would  be  an  absurdity.  In  the  first  instance  they  should 
have  been  fixed  so  that  the  remaining  value  of  the  plant,  plus  an  actual 
or  imaginary  amortization  fund,  based  on  full  expectancy  (which  may 
have  been  used  in  the  meantime  for  other  purposes),  remains  constant. 


TABLE  5.— Amortization  and  Annuities.     30- Year  Expectancy. 


Annual  Amortization  Increment  for 
Each  Dollar  Invested  =  $0.01783. 

Annuity 

which  will 

amount  to  $1 

in  the 

remaining 

life. 

♦Amount 
of  an 

At  the  end 
of  year. 

Amount  in 

amortization 

fund. 

Value 

remaining  in 

the  physical 

properties. 

Amount  of 
the  annuity  in 
the  remain- 
ing life. 

annuity  of 

$0,033^  in 

remaining 

life. 

1 

$0,000 
0.018 
0.056 
0.056 
0.076 
0.097 
0.118 
0.141 
0.164 
0.189 
0.214 
0.240 
0.269 
0.296 
0.326 
0.357 
0.389 
0.423 
0.456 
0.493 
0.531 
0.570 
0.611 
0.653 
0.697 
0.743 
0.790 
0.840 
0.890 
0.944 
1.000 

$1,000 
0.982 
0.964 
0.944 
0.034 
0.903 
0.882 
0.859 
0.836 
0.811 
0.786 
0.760 
0.731 
0.704 
0.674 
0.643 
0.611 
0.577 
0.544 
0.506 
0.469 
0.430 
0.389 
0.347 
0.303 
0.257 
0.210 
0.160 
0.110 
0.056 
0.000 

$1,000 
0.944 
0.890 
0.084 
0.790 
0.743 
0.697 
0.653 
0.611 
0.570 
0.531 
0.493 
0.456 
0.423 
0.389 
0.3.=.7 
0.326 
0.296 
0.269 
0.240 
0.214 
0.189 
0.164 
0.141 
0.118 
0.097 
0.076 
0.056 
0.036 
0.018 
0.000 

$0.01783 
0.01888 
0.02001 
0.02124 
0.02257 
0.02401 
0.02559 
0.02731 
0.02920 
0.03134 
0.03358 
0.03614 
0.03899 
0.04220 
0.04582 
0.04994 
0.05467 
0.06014 
0.06655 
0.07415 
0.08329 
0.0'.I449 
0.10853 
0.12661 
0.15079 
0.18463 
0.23550 
0.32038 
0.49020 
1.000 

$1,869 
1.765 

2 

1.665 

8 

1.569 

4 

1.477 

5... 

1.388 

6 

1.303 

7 

1.221 

8 

1.142 

9 

1.066 

10 

0.993 

11 

0.923 

12 

0.855 

13 

0.790 

14 

0.727 

15 

0.667 

16 

0  610 

17 

0.554 

18 

0  501 

19 

0.449 

20 

0  400 

21 

0  353 

22 

0  353 

23 

0  263 

24 

0  221 

25 

0  181 

26 

0  142 

27 

0  104 

28 

0  068 

29 

0  033 

30 

*The  annuity  here  noted  is  $1  divided  by  the  expectancy. 

'The  same  principle  applied  to  a  plant  made  up  of  a  number  of 
parts  with  various  periods  of  expectancy  will  show  that,  in  making 
appraisals    for    rate-fixing    purposes,    no    reduction    for    depreciation 


798 


THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES 


should  be  made  from  capital  actually  and  reasonably  invested,  pro- 
vided, of  course,  that  the  amortization  annuity  is  computed  on  the  basis 
of  full  expectancy  for  each  part.  ''■'! 

TABLE  6. — Amortization  and  Annuities.     40-Year  Expectancy. 


At  the  end 

of  year. 


1, 

2, 
3 
4. 
5, 
6, 
7, 
8, 
9, 
10, 
11, 
13 
13, 
14, 
15 
16 
17 
18, 
19, 
20 
21, 
22 
2-^, 
24, 
25, 
26, 
27 
28 
29 
80 
81 
32 
38 
34 
35 
36 
37 
38 
39 
40 


Annual  Amortization  Increment  for 
Each  Dollar  Invested  =  SO. 01052. 


Amount  in 

amortization 

fund. 


000 
Oil 
021 
033 
045 
057 
070 
083 
097 
112 
126 
142 
158 
175 
193 
211 
230 
249 
270 
291 
812 
836 
360 
385 
411 
438 
466 
.495 
526 
557 
590 
624 
660 
697 
735 
775 
817 
860 
905 
051 
000 


Value 

remaining  in 

the  physical 

properties. 


$1,000 
0.989 
0.978 
0.967 
0.955 
0.943 
0.930 
0.917 
0.903 
0.888 
0.874 
0.858 
0.842 
0.825 
0.807 
0.789 
0.770 
0.751 
0.730 
0.709 
0.687 
0.664 
0.640 
0.615 
0.589 
0.5t)2 
0.534 
0.505 
0.474 
0.443 
0.410 
0.H76 
0.340 
0.303 
0.265 
0.225 
0.183 
0.140 
0.095 
0.049 
0.000 


Amount  of 
the  annuity  in 
the  remain- 
ing life. 


$1,000 
0.951 
0.905 
0.860 
0.817 
0.775 
0.735 
0.697 
0.660 
0.024 
0.591 
0.557 
0.526 
0.495 
0.466 
0.438 
0.411 
0.385 
0.360 
0.386 
0.313 
0.291 
0.270 
0.249 
0.230 
0.211 
0.193 
0.175 
0.158 
0.142 
0.126 
0.112 
0.097 
0.083 
0.070 
0.057 
0.045 
0.033 
0.021 
0.011 
0.000 


Annuity 

which  will 

amount  to  $: 

in  the 

remaining 

life. 


80.01052 
0.01106 
0.01163 
0. PI 224 
0.01289 
0.01358 
0.01485 
0.01510 
0.01593 
0.01686 
0.01783 
0.01888 
0.02001 
0.02124 
0.C2257 
O.C2401 
0.02559 
0.02931 
0.02920 
0.03134 
0.03358 
0.0.S614 
0.08899 
0.04220 
0.04582 
0.04994 
0.05167 
0.06014 
0.067.55 
0.07415 
0.08329 
0.09549 
0.10853 
0.12661 
0.15079 
0.18463 
0.2a550 
0.82036 
0.49020 
1.000 


♦Amount  of 

an  annuity  of 

$0,025  in  the 

remaining 

life.    " 


g2.376 
2.260 
2.149 
2.042 
1.910 
1.841 
1.746 
1.655 
1.567 
1.483 
1.402 
1.324 
1.249 
1.177 
1.108 
1.041 
0.977 
0.915 
0.856 
0.799 
0.744 
0.692 
0.641 
0.582 
0.546 
0.501 
0.457 
0.416 
0.376 
0.337 
0.300 
0.265 
0.280 
0.197 
0,186 
0.185 
0.106 
0.078 
0.051 
0.025 


*  The  annuity  here  noted  is  $1  divided  by  the  expectancy. 
In  other  words:  Though  eminently  proper  to  deduct  depreciation 
when  determining  the  value  of  a  plant  for  an  owner  or  a  purchaser, 
it  is  fundamentally  wrong  to  make  such  deduction  when  the  plant 
is  being  appraised  for  rate  regulation,  unless,  as  will  be  hereinafter 
explained,  the  amortization  be  computed  thereafter  on  the  basis  of  the 
remaining  life  of  the  plant  or  of  its  parts. 


THE  APPRAISAL  OF  PUBLIC   SERVICE  PROPERTIES 


799 


TABLE  7. — Annuities  which   will  Amount  to  the  Remaining 
Value  of  Perishable  Property  in  its  Remaining  Life. 

For  each  SlOO  of  Original  Investment;  4%  Interest. 


This  can  best  be  made  clear  by  an  illustration:  Let  it  be  supposed 
that  the  passenger  rates  and  the  freight  tariff  on  a  steamboat  line  are 
subject  to  regulation,  and  that  some  one  going  into  the  steamboat 
business  builds  a  steamer  for  the  service.  Let  it  be  assumed,  too, 
that  in  connection  with  this  business  he  requires  no  capital  invest- 
ment other  than  the  cost  of  the  steamer,  that  terminal  facilities,  office 
space,  and  whatever  else  he  needs  are  obtainable  by  rental.  For  the 
purpose  of  this  illustration,  let  it  be  further  assumed  that  the  volume 
of  business  is  such  that  there  is  no  doubt  about  the  income,  so  that 
the  element  of  hazard  is  eliminated. 


800  THE  APPRAISAL  OP  PUBLIC  SERVICE  PROPERTIES 

If ,  now,  the  steamboat  has  a  life  of  20  years,  it  will  gradually  depre- 
ciate in  value  and  will  go  out  of  service  at  the  end  of  a  20-year  period. 
Ignoring  its  possible  scrap  value,  which  is  immaterial  for  the  purpose 
of  this  illustration,  the  following  questions  are  to  be  considered. 

At  the  end  of  10  years,  with  interest  at  4%  per  annum,  and  earnings 
just  sufficient  to  yield  interest  plus  an  amortization,  figured  for  a 
20-year  life  at  $0.03358  on  each  dollar  of  the  investment: 

1. — What  will  be  the  value  of  the  steamboat  to  the  owner  at  the 

end  of  10  years? 
2. — What  will  be  the  amount  that  a  purchaser  can  afford  to  pay 

for  the  steamboat  at  the  end  of  10  years? 
3. — What  should  the  earnings  be  during  the  time  the  steamboat 

is  in  possession  of  the  original  owner? 
4. — What  should  the  earnings  be  during  the  time  the  steamboat 
is  in  the  possession  of  a  purchaser  after  10  years  of  service? 

The  first  and  second  questions  have  already  been  answered.  The 
owner,  by  one  line  of  reasoning,  finds  the  remaining  value  in  the 
steamboat  to  be  59.7% ;  the  purchaser,  by  a  different  line  of  reasoning, 
finds  the  same  value. 

The  third  question,  too,  has  already  been  answered.  The  original 
owner  is  entitled  to  a  net  return  during  the  entire  period  of  his  owner- 
ship of  4%  on  his  investment,  which  is  at  all  times  100  per  cent. 
No  reduction  is  to  be  made  for  depreciation,  because  the  fund  which 
results  from  the  accumulation  of  the  amortization  annuity,  together 
with  its  interest,  is  available  for  no  other  purpose  than  the  replace- 
ment of  the  steamboat  at  the  end  of  its  period  of  usefulness.  It  is 
dead  capital,  and  remains  dead  until  the  property  is  disposed  of  or 
until  required  to  replace  the  worn-out  steamboat.  The  original  owner, 
therefore,  is  entitled  to  a  return  of  4  -f-  3.358  =  7.358%  per  annum  on 
his  investment. 

In  considering  the  fourth  question,  it  may  at  first  appear  as  though 
the  purchaser,  having  invested  only  59.7%  could  claim  a  return  on  this 
investment  alone — that  he  should  be  allowed,  in  addition  to  the  amorti- 
zation as  above  determined,  net  earnings  of  $2,388  (4%  on  $59.70) 
per  annum  on  what  he  paid  for  each  $100  of  the  original  cost  of  the 
steamboat;  that  the  valuation  for  rate-fixing  purposes,  in  other  words, 
should  be  the  original  investment  less  depreciation.  Under  the  adop- 
tion of  this  view,  it  will  be  seen  that,  if  the  steamboat  were  sold  re- 


THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES  801 

peatedly,  there  would  be  a  constantly  decreasing  appraisal  for  rate- 
fixing  purposes. 

In  the  last  year  of  its  service  the  valuation  entitled  to  considera- 
tion in  fixing  earnings  would  be  only  7  per  cent.  This  view  is  unfair 
to  the  owner  of  the  property,  who  should  be  assumed  to  be  planning 
a  continuation  of  the  steamboat  business.  When  he  takes  possession 
of  the  steamer,  its  value  to  him,  as  already  set  forth,  is  59.7%,  but,  as 
owner,  he  at  once  finds  that,  of  his  capital  ordinarily  available  for 
other  purposes,  an  amount  equal  to  40.3%  of  the  cost  of  a  new  steam- 
boat is  tied  up  in  his  steamboat  business.  It  has  become  dead  capital, 
for  all  purposes  except  replacement,  as  long  as  he  remains  in  the 
steamboat  business.  This  40.3%  at  interest  at  4%  is  necessary  to 
supplement  the  annuity  regularly  going  into  the  amortization  fund, 
together  with  which  at  the  end  of  the  20-year  period  it  will  just  re- 
place the  steamer.  Whether  or  not  the  40.3%  is  actually  set  apart  is 
immaterial;  the  fact  remains  that  ownership  of  the  depreciating 
steamer  renders  this  amount  of  capital  unavailable  or  dead  for  any 
purpose  other  than  replacement,  and  the  owner,  no  matter  when  he 
comes  into  possession,  is  entitled,  therefore,  to  interest  on  this  40.3% 
just  as  fully  as.  on  the  59.7%  which  he  paid  for  the  steamer. 

The  demonstration  of  this  fact  may  be  made  as  follows:  The  pur- 
chaser of  the  steamboat,  who  buys  the  boat  when  it  has  a  remaining 
period  of  usefulness  of  10  years,  invests,  as  has  been  explained,  $59.70 
for  each  $100  of  the  original  cost  of  the  steamboat.  He  is  unquestion- 
ably entitled  to  interest  on  this  sum,  together  with  amortization, 
which  at  the  assumed  interest  rate  of  4%  will  be : 

Interest  at  4%  on  $59.70 $2.39 

Amortization   at  8.33%  for  the  remaining  10  years,  during 

which  his  investment  is  paid  back  to  the  purchaser 4.97 

Total  $7.36 

This  is  exactly  the  same  as  though,  instead  of  the  value  of  the 
steamboat,  the  capital  originally  invested  had  been  taken  into  account, 
in  which  case  the  original  owner  or  purchaser  would  be  allowed: 

Interest  at  4%  on  the  investment  of  $100 $4.00 

Amortization  annuity  to  retire  $100  of  the  investment  within 

the  life  of  the  steamboat,  that  is,  within  20  years 3.36 

Total  $7.36 


803  THE  APPEAISAL  OF  PUBLIC  SERVICE  PROPERTIES 

Although  it  may  be  superfluous,  one  more  illustration  of  this  prin- 
ciple will  be  given:  Let  it  be  supposed  that  the  owner  borrows  money 
from  a  bank  at  4%  per  annum  to  build  a  steamboat,  and  that  he  earns 
4%  plus  the  amortization  increment  of  3.358  per  cent. 

Of  the  $Y.358  to  his  credit  at  the  end  of  each  year's  business  for 
every  $100  of  capital  invested,  he  pays  the  bank  $3,358  on  account  of 
principal  and  so  much  of  the  remaining  $4.00  as  may  be  necessary 
to  meet  the  interest  then  due.  This  will  be  all  of  the  $4.00  the  first 
year,  and  a  decreasing  amount  thereafter  until  the  end  of  the  20-year 
period,  when  his  steamboat  is  retired.  He  then  finds  that  he  has  al- 
ready paid  back  to  the  bank  on  account  of  the  borrowed  capital  twenty 
annuity  increments  of  $3,358,  amounting  to  $67.16,  and  that  there  is, 
therefore,  still  due  to  the  bank  $33.84.  He  also  finds  that  the  various 
amounts  remaining  in  his  hands  from  year  to  year,  $0,134  at  the 
end  of  the  second  year,  $0,269  at  the  end  of  the  third  year,  $0,336  at 
the  end  of  the  fourth  year,  and  so  on,  together  with  interest  thereon 
at  4%,  when  computed  for  the  20-year  period  will  amount  to  the  $33.84, 
the  balance  due  at  the  bank.  The  owner  finds  he  has  earned  nothing. 
He  has  made  no  investment  and  has  received  no  return,  which  is  as 
it  should  be  in  this  hypothetical  case.  The  rates,  however,  throughout 
the  entire  20  years  were  fixed  on  the  principle  that  4%  per  annum 
should  always  be  allowed  on  100%  of  the  capital  invested,  together 
with  the  amortization  annuity,  but  without  any  deduction  for  deprecia- 
tion. They  could  not  have  been  fixed  lower  without  entailing  loss  to 
the  owner. 

The  value  of  a  revenue  producing  property  when  the  earnings 
thereof  include  an  amortization  annuity  has  already  been  discussed. 
It  remains  to  consider  the  case  of  a  property  which,  in  addition  to  the 
accepted  reasonable  rate  of  interest  (net),  is  earning  a  replacement  in- 
crement determined  by  some  formula,  as  above  explained,  instead  of 
the  annuity  computed  from  amortization  tables. 

In  this  event,  each  part  of  a  plant  as  it  wears  out  is  replaced  out 
of  current  earnings.  The  owner  does  not  maintain  an  amortization 
fund,  neither  is  any  of  his  capital  rendered  dead  or  unavailable.  To 
him  the  value  of  the  property  is  at  all  times  100%;  so,  too,  in  the 
case  of  a  purchaser.  Knowing  that  the  replacement  is  covered  fully  in 
the  earnings,  he  is  willing  to  pay  100%  for  the  plant,  regardless  of  its 
depreciation. 


THE  APPEAISAL  OF  PUBLIC  SERVICE  PEOPERTIES  803 

Take  again  the  case  of  the  steamboat  with  a  life  of  20  years.  On 
the  assumption  that  the  replacement  cost  of  the  steamboat  will  be  re- 
turned to  him  when  the  steamboat  is  worn  out,  a  purchaser  will  pay 
for  it  at  any  time  in  its  life  100  per  cent.  Of  course,  in  the  case  of 
a  single  steamboat,  it  might  be  regarded  as  unreasonable  to  assume 
that  in  one  or  more  remaining  years  of  its  usefulness  it  will  earn 
enough  in  excess  of  reasonable  interest  on  capital  invested  to  pay 
for  a  new  boat;  but  if,  instead  of  one  steamboat,  there  were  twenty 
in  use,  and  the  annual  replacement  increment  were  one-twentieth  of 
the  invested  capital,  or  one  steamboat  each  year,  then,  without  hesita- 
tion, the  purchaser  would  value  the  property  at  100  per  cent. 

When,  therefore,  the  actual  average  annual  replacement  increment 
can  be  earned  in  excess  of  a  reasonable  interest  on  the  invested  capital, 
then  the  appraisal  for  an  owner,  for  a  purchaser,  and  for  rate-fixing 
purposes,  would  be  uniformly  and  always  100%  of  the  capital  invested. 
The  term,  "value,"  in  this  case,  means  the  same  to  the  original  owner, 
to  the  purchaser,  and  to  the  ratepayer. 

For  rate-fixing  purposes,  the  steamboat,  or  the  business  which  the 
steamboat  represents,  is  to  be  valued  throughout  the  entire  period  of 
the  steamboat's  usefulness  at  100% ;  and  the  earnings,  when  amortiza- 
tion is  included,  should  be  4  +  3.358  =  7.368%  on  this  valuation. 

Another  case  has  already  been  considered.  Suppose  that,  preceding 
the  time  of  an  appraisal  for  rate-fixing  purposes,  earnings  have  been 
inadequate  to  supply  any  amortization  increment,  and  that  it  be  de- 
termined thereafter  to  allow  the  actual  annual  replacement  require- 
ment to  be  earned.  What,  in  this  case,  should  be  the  appraisal? 
,,  The  original  investment  being  100%,  there  having  been  no  amorti- 
zation annuity  in  the  past,  there  can  be  no  transfer  of  the  property  at 
less  than  100%  without  loss;  but  if,  by  reason  of  inadequate  returns, 
the  market  value  could  not  be  maintained  at  100%,  and  a  sale  has  been 
made  at  less  than  this  sum,  the  new  owner  will  be  compensated  and 
protected  if,  on  his  investment,  which  is  not  original  cost,  he  earns 
reasonable  interest  and  an  adequate  amount  for  replacements.  This 
must  be  so,  because,  in  the  future,  actual  replacement  requirements 
being  covered  by  the  earnings,  the  worn-out  parts  will  be  replaced 
withoTit  cost  to  the  owner.  This  replacement  neither  increases  nor 
decreases  his  investment;  but,  if  the  property  is  extended  and  new  parts 
are  added,  such  additions  represent  newly  invested  capital  to  the  full 


804  THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES 

amount  of  their  cost,  and  in  such  a  case  his  investment,  expressed 
as  a  percentage  of  the  total  cost,  will  gradually  increase. 

At  all  times,  however,  without  causing  loss  to  the  new  owner,  that 
part  of  the  plant  which  he  bought  at  a  depreciated  value  could  be 
valued  at  his  purchase  price,  while  all  extensions  subsequent  to  the 
purchase  should,  for  rate-fixing  purposes,  be  appraised  at  100  per  cent. 
Such  a  course,  however,  would  deprive  the  new  owner  of  the  opportunity 
for  profit,  of  which  he  probably  thought  to  avail  himself  when  he  bought 
a  plant  of  depreciated  value,  and  would  place  the  rate-payer  in  the 
position  of  having  made  a  profit  at  the  expense  of  the  original  owner. 
This  fact,  however,  explains  why  the  market  value  of  stocks  and  bonds 
is  cited  so  frequently  as  an  indication  of  value. 

It  may  be  held  that  a  determination  of  value  for  rate-fixing  pur- 
poses, on  the  principles  herein  set  forth,  is  not  a  determination  of 
value  at  all.  This  may  be  true,  but  it  then  becomes  a  matter  of  de- 
fining "value,"  and  a  distinction  should  be  made  between  value  and 
the  appraisal  of  the  investment  on  which  rates  may  be  properly  based. 

The  term,  "value,"  has  been  very  generally  used  in  matters  involv- 
ing the  fixing  of  rates  in  the  past.  Perhaps  when  the  facts  herein  set 
forth  are  better  understood,  more  attention  will  be  paid  to  the  capital 
reasonably  and  properly  invested. 

The  illustration  with  a  steamboat  which,  though  subject  to  constant 
depreciation  in  value,  is  rendering  the  same  adequate  service  through- 
out its  entire  period  of  usefulness,  was  selected  because  thereby 
the  fundamental  principle  involved  is  made  plain.  This  principle 
is  much  less  apparent  when  a  plant  made  up  of  many  parts  of  various 
ages  and  of  various  periods  of  usefulness  is  under  consideration.  For 
example,  a  plant  more  than  40  years  old,  of  gradual  growth,  all  parts 
of  which  have  a  life  of  40  years,  would  have  a  selling  value  of  63.80%, 
if  the  proper  provision  for  amortization,  based  on  full  expectancy, 
has  been  made;  but,  in  such  case,  it  should  earn  reasonable  interest 
on  100%  of  its  cost.  ^«wq 

A  plant  more  than  20  years  old,  made  up  of  many  elements  or  parts, 
all  having  a  useful  life  of  20  years,  but  constructed  one-twentieth  each 
year,  should  be  worth  58.95%  to  a  purchaser,  but,  with  provision  for 
amortization,  as  above,  should  earn  a  reasonable  interest  on  100% 
of  its  cost. 

A  plant  more  than  5  years  old,  all  parts  of  which  have  a  life  of 


THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES  §08 

5  years,  constructed  one-fifth  each  year,  should  be  worth  61.58%  of 
cost  to  a  purchaser,  but  when  the  allowance  for  amortization  is  based 
on  full  expectancy,  a  reasonable  interest  should  be  earned  in  addition 
thereto  on  100%  of  the  investment. 

It  follows  from  the  foregoing,  not  only  that  for  rate-fixing  the  ap- 
praisal may  properly  be  of  the  capital  invested,  but  that,  in  de- 
termining this  capital,  the  aggregate  replacement  cost,  within  periods 
not  greater  than  the  expectancy  of  the  several  perishable  parts  of  a 
public  service  plant,  may  have  to  be  taken  into  account. 

The  amount  which  should  be  returned  to  the  owner  as  a  replacement 
allowance  is  the  capital  actually  invested  in  the  part  of  the  plant  re- 
placed from  time  to  time.  It  is  not  the  original  cost,  but  the  cost  at 
the  last  renewal,  which  is  to  be  returned  to  him,  and  which  he  is  ex- 
pected to  re-invest  with  such  addition  thereto  or  subtraction  therefrom 
as  changed  conditions  may  compel. 

The  account,  as  far  as  a  discarded  appliance  is  concerned,  is  closed, 
and  the  new  appliance  which  takes  its  place,  in  fact  represents  new  in- 
vestment; and  in  its  appraisal  no  note  whatever  is  to  be  taken  of  the 
conditions  under  which  its  predecessor  was  constructed,  or  installed. 

The  appraisal  of  capital  invested,  therefore,  should  deal  with  con- 
ditions as  they  have  prevailed  during  a  longer  or  shorter  period  antedat- 
ing the  time  of  the  appraisal.  When  a  complex  plant  is  under  con- 
sideration, prices  used  in  estimating  cost  should  be  average  prices 
and  not  those  prevailing  at  any  particular  time. 

Under  a  system  of  permitting  the  owner  of  public  service  properties 
to  earn  from  year  to  year  the  actual  average  replacement  require- 
ments, the  necessity  for  a  close  distinction  between  repair  and  re- 
placement disappears.  This  is  of  some  advantage,  as  it  is  at  best 
difficult  to  discriminate  between  small  items  of  replacement  and  large 
repair  items. 

By  the  foregoing  reasoning  the  conclusion  seems  inevitable  that 
there  may  be  cases  in  which  large  public  service  properties,  such  as 
sewer  systems,  harbors,  railroads,  and  the  like,  the  ownership  of  which 
is  not  limited  in  time  by  franchise,  may  be  regarded  as  more  or  less 
complex  plants,  having  practically  perpetual  life.  The  appraisal  for 
rate-fixing  purposes  is  then  at  the  full  amount  of  capital  reasonably 
and  properly  invested,  and  there  will  be  no  deduction  therefrom  for 
depreciation.     There  will  be  no  amortization  if  constructed  on  a  cash 


806  THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES 

basis,  and.  all  repair  and  replacement  requirements  will  then  appear  in 
the  expense  of  operation  and  maintenance,  but  with  due  regard  to  all 
the  elements  that  should  be  taken  into  account. 

Beal  estate  is  usually  considered  as  requiring  no  allowance  for 
depreciation,  because,  as  a  rule,  real  estate  does  not  depreciate  in  value. 
However,  cases  are  conceivable  where  there  is  depreciation,  where,  pos- 
sibly by  reason  of  the  advance  in  the  arts  and  abandonment  of  certain 
properties,  the  encumbered  ground  on  which  useless  improvements  are 
located  may  have  less  value  than  its  original  cost.  ,q 

In  such  cases,  if  they  could  be  foreseen,  there  might  well  be  some 
allowance  for  depreciation.  Ordinarily,  however,  there  is  a  gradual 
increase  in  the  value  of  real  estate.  This  increase,  strictly  speaking, 
should  be  regarded  as  earnings,  a  point  to  which  reference  will  be  made 
later.  As  a  rule,  the  present  value  of  real  estate,  in  lieu  of  its  first  cost 
plus  such  improvements  as  grading,  bulkheading,  reclaiming  against 
submersion,  street  and  sewer  work,  and  the  like,  may  be  entered  on 
the  appraisal.  As  the  present  value  can  generally  be  readily  ascer- 
tained, this  is  usually  adopted  as  a  sufficiently  close  approximation  of 
capital  invested  in  real  estate. 

Intangible   Values. 

Ordinarily,  there  is  neither  occasion  for  nor  propriety  in  adding, 
to  an  appraisal  for  rate-fixing  purposes  of  a  public  service  property, 
anything  for  intangible  values,  such  as  franchise,  going  concern,  and 
the  like.  When  an  addition  to  the  appraisal  for  these  is  made,  it  is 
most  likely  for  the  purpose  of  giving  a  name  to  an  addition  which 
is  necessarily  more  or  less  arbitrary. 

This  statement,  of  course,  does  not  apply  when  the  State  or  a 
municipal  authority  has  been  paid  for  a  franchise.*  The  cost  of  the 
franchise,  in  such  a  case,  is  a  part  of  the  legitimate  investment  of 
capital,  and  must  be  included  in  the  appraisal.  The  same  is  true  of 
water  rights.  Where  adverse  rights  have  to  be  quitted,  or  where,  as 
under  a  new  law  in  California,  the  State  makes  a  charge  for  water 
rights,  their  cost  is  a  legitimate  expenditure,  and  should  not  be 
classed  among  the  intangible  values  in  the  sense  in  which  the  term  is 
here  used.  '^ 

Neither  does  the  foregoing  statement  relating  to  intangible  values 

*  In  San  Francisco,  for  example,  franchises  for  streiet  car  lines  are  sold  to  the  highest 

bidder.  _■ :  ji  ;  .U  Vui 


THE  APPRAISAL  OF  PUBLIC   SERVICE  PROPERTIES  807 

apply  when  the  appraisal  is  made  of  a  property  having  a  definite 
earning  capacity.  The  sum  of  all  intangible  values  is  then  determined 
by  capitalization  of  net  earnings  and  by  deducting  from  such  capitali- 
zation the  valuation  of  the  physical  properties. 

When  rates  are  being  fixed,  it  is  quite  proper  to  allow  earnings  in 
excess  of  earnings  on  ordinary  safe  investment.  Such  allowance  may 
be  made  either  direct,  as  an  addition  to  the  allowed  rate  of  interest,  or 
in  the  roundabout  way  of  an  addition  to  the  appraisal. 

It  is  possible,  of  course,  in  the  case  of  large  earnings  in  the  past, 
that  a  portion  thereof  should  be  considered  as  capital  returned  to  the 
owner.  In  such  a  case  the  fact  may  be  of  some  importance  that  an 
appraisal  at  100%  of  the  investment  would  already  include  some  of  the 
intangible  value. 

When  the  annual  amortization  increment  has  not  been  fully  covered 
by  the  earnings,  the  deficiency  is  a  loss.  This  can  be  made  good  to 
the  owner  only  by  increasing  the  earnings,  which,  as  previously  stated, 
is  sometimes  done  by  computing  the  interest  to  be  earned,  not  on  the 
invested  capital  alone,  but  on  the  investment  plus  the  aggregate  defi- 
ciency in  the  earnings  of  past  years.  Such  deficiency  of  earnings, 
however,  can  hardly  be  regarded  as  an  element  of  value. 

Intangible  values,  of  whatsoever  nature,  result  from  high  earnings. 
In  the  case  of  public  service  corporations,  they  are  arbitrarily  created 
by  agreeing  to,  and  permitting,  rates  which  produce  a  revenue  in. 
excess  of  the  ordinary  return  on  safe  investments.  They  do  not  exist 
unless  the  rates  are  higher  than  those  which  would  produce  net  earn- 
ings equalling  an  ordinary  interest  return  on  the  properly  invested 
capital. 

It  is  eminently  proper  to  treat  expenditures  such  as  the  interest 
on  capital  during  construction  as  an  item  of  cost;  yet  the  propriety 
of  doing  this  is  sometimes  questioned.  An  inadequate  interest  return 
during  the  development  stage  is  another  matter.  Expenditures  may  be 
incurred  which  can  be  classed  as  development  expense,  such  as  adver- 
tisements and  the  salaries  of  business  solicitors,  but  these  are  ordinarily 
and  with  perfect  propriety  classed  as  general  expense,  or  are  otherwise 
included  in  the  operating  expense,  and  enter  into  consideration  when 
net  earnings  are  estimated.  In  other  words,  they  should  be  repaid 
from  year  to  year  as  they  are  incurred,  and  should  not  be  considered 
as  a  part  of  the  capital  on  which  the  owner  is  entitled  to  a  return. 


808  THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES 

In  some  cases,  it  may  be  possible  to  segregate  such  expenditures 
and  to  determine,  too,  whether  they,  together  with  the  aggregate  loss 
of  interest  during  the  unproductive  period  in  the  history  of  a  plant 
or  of  parts  of  a  plant,  have  already  been  made  good  by  high  rates  in 
the  past.  If  this  is  found  to  be  the  case,  the  element  of  hazard  is  to 
a  large  extent  eliminated. 

The  public  service  corporations,  naturally,  would  prefer  to  have 
the  losses  during  the  lean  years,  and  such  expenditures  as  the  adver- 
tising of  the  business,  classed  as  investment  of  capital.  The  apparent 
investment  is  thereby  increased  and  the  apparent  aggregate  profits 
of  the  business  figured  from  the  beginning  of  the  operations  are 
thereby  made  to  appear  larger  than  they  would  otherwise. 

The  fact  that  interest  during  construction  is  properly  considered 
a  part  of  cost  is,  as  a  matter  of  course,  as  true  of  all  work  of  exten- 
sion and  replacement  as  it  is  of  original  construction. 

Where,  as  in  California,  the  water  companies  and  the  gas  com- 
panies operate  under  constitutional  privileges,  without  special  fran- 
chise, the  hazard  of  the  business  should  be  covered  in  the  earnings, 
and  these  earnings  should  amortize,  in  the  course  of  time,  a  reason- 
able allowance  for  inadequate  earnings,  or  other  unavoidable  losses 
of  past  years.  This,  of  course,  can  be  done  by  making  an  arbitrary 
addition  to  an  appraisal,  but  then,  as  already  stated,  the  hazard  of 
the  business  is  thrown  in  large  measure  on  the  ratepayer,  and  the  rate 
of  return  must  be  relatively  low.  It  is  quite  as  effective  to  keep  the 
appraisal  low  and  make  the  rate  of  return  relatively  high. 

There  seems  to  be  no  question  that  the  paxt  of  value  usually 
designated  as  "going  concern"  is  intended  to  apply  to  the  advantage 
which  an  established  business  has  over  a  corresponding  prospective 
business,  foreseen  as  the  result  of  investment,  but  not  yet  established. 

As  long  as  the  business  is  unprofitable,  and  as  long  as  the  rates 
charged  do  not  yield  a  net  return  on  the  invested  capital  which 
exceeds  the  return  obtainable  from  savings  banks  or  from  other  invest- 
ments of  a  character  regarded  as  safe  in  the  ordinary  acceptance  of 
this  term,  the  business  has  no  "going  concern"  value.  This  value, 
like  franchise  value,  can  result  only  from  a  capitalization  of  the  excess 
of  net  earnings  over  the  return  on  ordinary  safe  investments.  It  is 
generally  a  purely  fictitious  value,  without  basis  other  than  that  which 
results  from  high  net  earnings,  but  may  be,  and  often  is,  regarded 


THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES  809 

and  defined  as  that  portion  of  the  intangible  value  for  which  some  sort 
of  a  demonstration  can  be  offered,  as,  for  example,  the  equity  of 
making  good  early  losses  and  the  deficient  earnings  of  the  past,  or 
some  estimated  cost  of  establishing  the  business  at  the  time  of  the 
appraisal,  including  loss  of  interest  during  an  assumed  time  which 
would  be  required  for  reconstruction.  It  is  held,  with  some  reason, 
that  in  equity  it  is  proper  to  assume  that,  if  the  community  which  is 
served  by  a  public  service  property  had  undertaken  construction  and 
management  itself,  it  would  have  subjected  itself  to  the  same  losses, 
or  at  any  rate  to  the  same  chances  of  loss,  as  the  owner  of  the  prop- 
erty, who  is  in  some  measure  at  least  to  be  regarded  as  agent  and  who, 
as  such  agent,  should  neither  be  made  to  suffer  unavoidable  losses 
nor  yet  be  allowed  to  make  unreasonable  profits. 

The  special  franchise,  when  one  exists,  defines  the  limits  within 
which  an  owner  must  operate.  If  it  does  not  permit  rates  which  will 
make  the  net  earnings  adequate,  then  the  losses  must  fall  without 
recourse  on  the  owner;  if,  on  the  other  hand,  the  net  earnings  are 
greater  than  the  returns  on  safe  investments,  then,  with  due  regard 
for  the  time  during  which  the  rates  are  protected  by  the  franchise, 
these  earnings  are  the  basis  from  which,  with  a  fair  degree  of  preci- 
sion, the  aggregate  amount  of  intangible  values  may  be  determined. 
These  values  collectively  must  be  the  difference  between  the  capitali- 
zation of  the  total  net  earnings  (properly  determined)  and  the  capital 
which  remains,  at  any  particular  time,  as  an  investment  in  the 
property. 

The  early  losses  and  deficient  earnings,  when  they  are  added  to  the 
valuation,  are  regarded  by  the  appraiser  as  a  part  of  the  investment 
which  had  to  be  made  to  get  the  business  going— to  establish  it — 
or  at  any  rate  to  carry  it  along  until  it  was  on  a  paying  basis.  If 
this  procedure  should  be  generally  accepted,  it  would  result  in  giving 
to  ''going  concern"  the  greatest  value  in  those  cases  where,  at  the 
outset  of  the  undertaking,  conditions  were  the  most  unfavorable.  This 
is  an  absurdity,  because  the  valuation  should  be  a  valuation  under 
present-day  conditions,  and  the  actual  advantage  which  an  established 
business  has  over  another  that  would  result  from  a  duplication  of  the 
plant  may  be,  and  generally  is,  entirely  independent  of  the  conditions 
which  prevailed  when  the  established  business  was  in  its  infancy. 

It  may  be,  of  course,  and  sometimes  has  been  held,  that,  if  unsuc- 


810  THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES 

cessful  work  and  early  losses  are  not  to  be  added  to  the  cost  of  a 
property,  interest  during  construction  likewise  should  not  be  treated 
as  cost;  but,  in  one  case,  there  is  no  limit  to  the  possible  amount  of 
unproductive  expenditure,  while,  in  the  other,  a  definite  assumption 
applicable  in  practically  all  cases  can  be  made.  It  is  not  unfair  to 
assume,  for  example,  that  in  case  of  water-  or  gas-works  of  mature 
age  and  gradual  development,  some  period  of  time,  most  naturally  for 
small  investments  one  year,  will  cover  the  average  time  before  they 
commence  to  be  remunerative.  Where  large  and  complex  works  are 
under  consideration,  the  cost  for  one-half  of  the  period  of  construction 
may  be  a  fair  allowance.  The  amounts  thus  determined  are  incident 
to  every  construction,  whether  new  or  whether  in  the  nature  of  a 
hypothetical  replacement,  and,  therefore,  with  perfect  propriety,  may 
be  added  to  cost.  It  is  not  so  with  the  expenditures  of  uncertain  and 
extremely  variable  amount  which  may  be  made  for  unsuccessful  work. 
There  may  be  none  in  one  case,  while  in  another  they  may  be  very 
large,  as,  for  example,  in  the  case  of  the  failure  of  an  expensive 
structure  like  a  dam. 

While  the  early  losses  and  the  expenditures  for  unsuccessful  work 
are  not  a  measure  of  going  concern  value,  they  are  nevertheless  of 
that  class  of  expenditures  which,  in  whole  or  in  part,  as  already  stated, 
should  come  back  to  the  owner  of  the  property  sooner  or  later.  To 
add  them  in  the  exact  amount  shown  by  the  cost  records  in  any 
particular  case  is  not  an  invariably  fair  procedure.  The  owner  who 
builds  with  care  and  under  the  best  expert  advice  and  has  no  such 
losses  is  entitled  to  a  reward  for  his  good  judgment  and  for  the  care 
with  which  he  has  executed  the  works.  The  "going  concern"  value  of 
such  works  is  certainly  as  great  as  the  going  concern  value  of  other 
works  of  a  similar  character  and  extent  which,  by  reason,  perhaps,  of 
less  care  in  design  and  execution,  involved  a  large  expenditure  for  un-t 
successful  work  and  for  the  development  of  the  business. 

The  combined  experience  on  all  works  of  a  similar  character,  how- 
ever, should,  in  the  long  run,  establish  the  addition  which  should 
in  fairness  be  made  to  the  earnings  to  amortize  an  assumed  fair 
allowance  for  this  class  of  expenditures  within  a  reasonable  and  not 
too  short  time.  This  addition  may  be  relatively  large  for  one  type  of 
works  and  small  for  another.  It  seems  fair  to  assume  that  it  should 
be  relatively  small  when  the  total  values  are  high.      .  ,<.    -  ,    .j.^^ 


THE  APPRAISAL  OF  PUBLIC   SERVICE  PROPERTIES  811 

■f-  Occasionally,  a  definite  basis  for  at  least  a  part  of  the  value  as  an 
established  business  can  be  found.  For  example,  there  are  cases  in 
which  the  cost  of  making  a  connection  with  a  water  or  gas  main  is 
a  charge  in  whole  or  in  part  against  the  consumer.  In  such  cases  the 
cost  of  making  the  connection  is  no  part  of  the  capital  invested  by 
the  owner  of  the  water-  or  gas-works,  and  should  not  be  included  in 
an  appraisal  of  the  physical  properties;  but,  to  the  extent  of  the  cost 
of  renewing  the  connections  with  a  new  system  of  mains,  the  estab- 
lished company  has  a  distinct  and  easily  recognized  advantage  over 
any  new  company.  While  not  to  be  taken  into  account  at  all  in 
making  appraisals  for  rate-fixing  purposes,  it  may,  when  intangible 
values  under  special  franchises  are  to  be  determined,  be  regarded  as 
a  part  of  the  aggregate  intangible  value  obtained  by  capitalizing  the 
excess  of  the  earnings  over  the  ordinary  return  on  safe  investments 
not  involving  management.  ^^ 

It  appears  from  the  foregoing  that,  no  matter  how  accurately  the 
aggregate  of  the  intangible  values  may  be  determined,  it  is  frequently 
impossible  to  find  any  other  than  an  arbitrary  basis  for  separating 
them  into  such  subdivisions  as  "going  concern,"  "development  of 
business,"  "franchise,"  "unification  of  system,"  and  the  like.  Fortu- 
nately, such  separation  is  rarely  necessary,  and,  when  attempted,  is 
usually  only  for  the  purpose  of  giving  a  reason  why  .  an  arbitrary 
allowance  of  earnings  above  those  on  ordinary  safe  investments  is 
just  and  proper. 

When  the  losses  during  lean  years,  or  deficient  earnings,  or  un- 
productive expenditures,  such  as  water  tunnels  or  wells  which  produce 
no  water,  structures  that  fail  during  erection,  damage  by  fire,  flood, 
earthquake,  or  explosions  during  erection,  are  added  to  the  value  as 
"going  concern,"  this  is  unnecessary  and  forced.     These,  as  has  been 
stated,  are  losses,  and,  therefore,  are  to  be  considered  and  treated  as 
the  reverse  of  earnings.     They  cannot  in  all  cases  with  propriety  be 
added  to  the  valuation  of  the  physical  properties,  though  it  may  be 
H.    eminently  proper,  on   account  of  such  originally  unforeseen   circum- 
H;  stances,  to  estimate  the  cost  of  reproduction  liberally. 
|B|         In  some  form  they  should  be  taken  into  consideration  in  fixing 
rates.    It  is  rarely  practical  to  determine  such  losses  with  accuracy,  and 
yet  it  is  well  known  that  very  few  public  service  plants  commence 
operation  without  some  untoward  experience  or  without  being  com- 


812  THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES 

pelled  to  do  business  for  a  time  at  a  loss.  Frequently,  the  expendi- 
tures for  unproductive  work  are  large,  and  yet  this  unproductive  work 
should  ordinarily  be  assumed  to  have  been  done  under  competent 
advice.  It  is  assumed,  in  other  words,  that  it  could  not  be  foreseen 
that  what  turned  out  to  be  unproductive  work  would  have  no  value. 

The  easy  way  out  of  the  trouble  of  providing  compensation  for 
such  expenditures  is  the  one  frequently  recommended,  to  add  them  to 
the  valuation,  giving  them  a  name  and  treating  them  as  a  part  of  the 
intangible  value;  but,  while  this  may  appear  reasonable  in  ordinary 
cases,  where  the  expenditure  for  useless  work  and  the  losses  in  lean 
years  have  been  small,  other  cases  have  occurred  and  can  be  foreseen, 
as  already  explained,  in  which  the  problem  wiU  not  be  as  easy  of 
solution.     It  is  never  logical. 

Where  there  has  been  loss  due  to  some  unforeseen  condition,  due 
perhaps  in  part  to  error  of  judgment  and  to  lack  of  proper  foresight 
by  the  owner,  it  is  eminently  proper  to  let  a  part  of  this  loss  fall  on 
the  owner.  When  he  embarks  upon  the  enterprise  he  must  be  sup- 
posed to  do  so  with  the  fixed  purpose  of  reaping  a  profit: 

*'       1st. — In  the  high  rates  which  the  people  practically  guarantee  to 
the  owner; 
2d. — In  the  advance  in  real  estate  and  other  values  which  make  up 
■■  the  business. 

If,  now,  such  anticipated  increase  in  value  is  allowed  to  the  owner 
and  the  rates  are  fixed  with  a  view  to  covering  the  ordinary  hazards 
of  installation  and  operation,  and  to  provide  proper  compensation  for 
management,  then  the  owner  on  his  part  must  stand,  in  part  at  least, 
the  unforeseen  losses,  such  as  the  destruction  by  flood  of  a  partly 
finished  dam,  in  the  assurance  that  in  the  long  run  these  losses  will  be 
made  good,  as  far  as  they  ought  to  be  made  good,  by  adequate  com- 
pensation for  the  service  which  he  renders. 

a  It  follows  that  all  intangible  values  (as  they  may  come  into  con- 
sideration apart  from  appraisals  for  rate-fixing  purposes)  should  re- 
sult from  the  inclusion  of  some  more  or  less  arbitrary  allowance  in 
the  established  rates  such  that  earnings  will  exceed  in  some  prede- 
termined measure  the  earnings  which  would  just  yield  the  ordinary 
interest  rate  on  safe  investments  when  applied  to  the  reproduction 
cost  of  the  plant,  or  better  yet,  when  applied  to  the  actual  capital 


THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES  813 

reasonably  and  properly  invested.  When,  for  any  purpose,  considera- 
tion is  given  to  intangible  values  thus  determined,  it  will  matter  but 
little  what  name  is  used  to  designate  them.  It  becomes  comparatively 
easy,  too,  in  such  a  case,  to  establish  a  proper  relation  between  the 
tangible  and  intangible  values,  such  that  both  owner  and  ratepayer 
may  receive  equitable  treatment. 

If  it  is  proper  to  add  anything  for  early  losses,  unproductive  in- 
vestments, and  cost  of  developing  business  to  an  appraisal,  then  it 
is  equally  proper,  in  fairness  to  the  ratepayer,  to  exclude  from  the 
appraisal  all  accessions  of  value,  all  appreciations  which  result  from 
advance  in  the  value  of  real  estate  and  like  causes,  and  it  will  also 
be  fair  and  proper  to  keep  the  net  earnings  at  and  not  above  the 
ordinary  return  on  safe  investments. 

When  the  cost  of  unproductive  work,  as  just  referred  to,  is  added 
to  the  capitalization,  it  is  with  the  idea  that  this  addition  shall  be 
treated  for  all  time  as  a  part  of  the  investment,  and  not  as  a  loss,  and 
that  the  ratepayer  must  bear  the  additional  burden  for  all  time.       :-,r} 

When  the  cost  of  useless  elements  or  early  losses  in  the  business 
are  treated  as  losses,  they  should  in  a  fair  measure  be  made  good  in 
the  course  of  time  out  of  adequate  earnings,  and  this  should  be  done 
irrespective  of  whether  every  item  of  early  loss  or  of  every  unprofitable 
investment  can  be  remembered  or  not. 

The  most  logical  course  to  be  pursued,  and  the  one  which  is  always 
open  to  the  appraiser,  is  to  use  the  best  available  means  for  determin- 
ing the  amount  of  capital  which  is  properly  invested,  then  determine 
what  the  earnings  should  be  to  yield  an  ordinary  return  on  the  in- 
vestment thus  ascertained,  and  then  to  increase  those  earnings  by  an 
arbitrary  amount,  which  may  vary  within  wide  limits,  not  only  to  com- 
pensate for  past  losses  and  for  the  hazard  during  construction  and 
operation,  but  also  as  a  compensation  for  management. 

In  doing  this,  however,  every  endeavor  should  be  made  to  determine 
correctly  the  cost  of  operation  and  maintenance.  Maintenance  is 
here  used  in  its  broadest  sense,  and  must  include  amortization.  Care 
must  be  taken,  also,  not  to  confound  amortization  with  depreciation, 
because,  as  has  been  explained,  an  amortization  annuity,  figured  at 
compound  interest,  is  not  available  to  retire  invested  capital  until  at 
the  end  of  the  life  of  a  plant,  and  the  existence  of  an  amortization 


814  THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES 

fund  is  not  in  itself  a  reason  for  decreasing  the  capital  allowance  on 
which  interest  is  to  be  earned. 

Fundamental  Principles. 

1. — The  valuation  of  a  public  service  property  and  its  earnings 
must  bear  such  relation  to  each  other  that  there  will  be  returned  to 
the  owner,  within  the  life  of  the  property,  the  capital  which  he  has 
properly  invested  in  it,  and  in  addition  thereto,  interest  at  a  reason- 
able rate,  upon  such  amount  of  capital  as  from  time  to  time  actually 
and  properly  remains  in  the  property  as  an  investment. 

2. — Amortization  by  the  annuity  method  (the  amortization  or  de- 
preciation annuity  being  based  on  the  full  expectancy)  is  amortization 
at  the  end  and  only  at  the  end  of  the  period  embraced  in  the  expectancy. 
The  invested  capital  remains  uniform  throughout  the  entire  period. 

S. — In  the  case  of  amortization  by  the  annuity  method,  the  value 
of  a  plant  as  it  would  be  determined  for  a  purchaser  is  the  cost  of 
replacement  (or  original  investment)  less  the  amount  of  the  amortiza- 
tion or  depreciation  annuity  at  the  time  of  purchase. 

4. — Amortization  by  the  straight-line,  or  direct  percentage,  method 
is  amortization  in  annual  installments.  The  invested  capital  is  re- 
duced from  year  to  year. 

5. — In  the  case  of  amortization  by  the  straight-line,  or  direct  per- 
centage, method,  value  and  the  appraisal  for  rate-fixing  purposes  are 
determined  in  the  same  way. 

6. — When  the  annual  earnings  are  just  adequate  to  meet  operating 
expenses,  interest,  and  the  annual  replacement,  the  amount  set  apart 
for  replacements  will  not  reduce  the  invested  capital. 

7, — A  public  service  property  which  consists  of  a  single  perishable 
item  may,  at  any  time  of  its  life,  be  appraised  at  100%  of  the  capital 
properly  invested,  provided  that  amortization,  estimated  by  the  annuity 
method  for  the  full  expectancy,  has  been  allowed  from  the  beginning. 

8. — A  public  service  property  which  consists  of  a  single  perishable 
item  may,  at  any  time  of  its  life,  be  appraised  at  the  investment  less 
depreciation  (determined  by  any  method),  and  amortization  may  then 
be  computed  for  the  remaining  value  thus  determined,  but  must 
be  based  on  the  remaining  years  of  the  property's  usefulness. 

9. — A  public  service  property  made  up  of  numerous  items,  all  df 
which  have  the  same  expectancy,  may  be  appraised  at  100%  of  the 


THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES  815 

investment,  and  amortization  should  then  be  allowed  from  the  begin- 
ning, and  the  full  expectancy  should  be  used  in  computing  it. 

10. — A  public  service  property  made  up  of  numerous  items,  all  of 
which  have  the  same  expectancy,  may  have  each  item  valued  separately, 
as  under  Paragraph  8,  with  deduction  for  depreciation,  and  with  amor- 
tization allowed  for  the,  remaining  life  of  each  item. 

11. — A  public  service  property,  of  gradual  growth  and  mature  age, 
made  up  of  numerous  items  of  the  same  expectancy,  when  the  assump- 
tion is  justified  that  the  annual  rate  of  extension  has  been  uniform, 
may  be  appraised  at  investment  less  an  average  depreciation,  and 
amortization  is  then  to  be  allowed  for  the  equivalent  remaining  life 
of  an  equivalent  single  item. 

12. — When  a  public  service  property  is  made  up  of  many  items 
of  various  expectancies,  the  property  may  be  appraised  at  100%  of  the 
investment,  and,  amortization  being  allowed  from  the  beginning,  this 
is  to  be  estimated  on  the  basis  of  the  full  expectancy  of  each  group 
of  items  of  equal  expectancy. 

IS. — When  a  public  service  property  is  made  up  of  many  items  of 
various  expectancies,  each  item  may  be  dealt  with  separately,  as  under 
Paragraph  8,  or  groups  of  items  may  be  dealt  with,  as  under  Para- 
graph 11. 

IJt. — When  the  special  case  is  presented  in  which  there  has  been 
no  amortization  earned  in  the  past,  it  will  be  proper  to  substitute  the 
annual  actual  replacement  requirement  in  lieu  of  amortization.  The 
appraisal  should  then  be  at  100%  of  the  capital  properly  invested. 

15. — When  the  amortization  annuity  is  based  on  the  full  expectancy 
and  remains  at  this  amount  throughout  the  life  of  a  plant,  then  no 
part  of  the  amortization  can  be  applied  to  retire  the  investment  until 
the  close  of  the  period  of  useful  life,  when  the  amortization  fund  will 
be  equal  to  the  investment.  In  case  it  be  thus  applied,  a  new  amor- 
tization rate  for  the  remaining  life  and  the  remaining  value  must 
be  introduced  into  the  calculation.  Table  7  gives  such  rates  for  a  few 
expectancies. 

16. — When  the  appraisal  for  rate-fixing  purposes  is  investment  less 
depreciation,  and  earnings  have  not  included  amortization  in  the  past, 
then,  under  amortization  computed  by  the  annuity  method  for  the  full 
original  expectancy,  the  owner  will  be  operating  at  a  loss. 


816  THE  APPRAISAL  OF  PUBLIC   SERVICE  PROPERTIES 

n. — Proper  investments  for  franchises,  for  water  rights,  and  the 
like,  are  always  to  be  included  in  the  appraisal. 

18. — Intangible  values  should  be  disregarded,  in  making  appraisals 
for  rate-fixing  purposes,  excepting  only  when  the  rate  of  net  return 
is  deliberately  fixed  at  or  too  near  the  rate  earned  by  ordinary  safe 
investments,  in  which  case  an  arbitrary  addition  to  the  appraisal,  under 
whatever  name,  should  be  made.  The  interest  on  this  item  of  the  ap- 
praisal will  be  the  reward  of  the  owner  for  management  and  for  any 
hazard  which  the  business  may  involve. 

19. — The  net  earnings  of  a  public  service  property  should  in  some 
measure  exceed  the  return  frora  ordinary  safe  investments. 

20. — The  appraisal  of  real  estate  should  be  at  its  present  value. 

21. — When  the  increase  of  the  value  of  a  public  service  property, 
due  to  increase  in  the  value  of  real  estate  or  like  causes,  is  determinable 
in  advance,  such  increase  may  be  taken  into  account  as  a  part  of 
the  current  earnings. 

22. — When,  in  the  past,  there  has  been  increase  of  value,  due  to 
increase  in  value  of  real  estate  or  like  causes,  this  is  to  be  offset  against 
losses  during  lean  years.  The  increase  in  value  represents  reinvested 
earnings. 

It  is  to  be  noted,  as  set  forth  in  Paragraphs  8,  10,  11,  and  13,  that 
a  valuation  for  rate-fixing  purposes  at  less  than  the  original  invest- 
ment of  capital  may  be  perfectly  proper.  It  represents  the  remaining 
investment;  but,  when  the  original  investment  less  amortization  or  de- 
preciation is  introduced  into  the  calculation,  amortization  requires 
special  consideration,  because  it  must  be  entered  at  a  new  and  in- 
creasing amount  from  year  to  year.  Reference  may  be  had  to  Table  7, 
which  makes  this  point  clear. 

Notwithstanding  the  great  disadvantage  attendant  upon  valuation 
at  original  investment  less  depreciation,  such  valuations  are  being 
made  and  are  therefore  being  herein  fully  considered. 

In  explanation  of  the  statement  that  the  earnings  of  a  public  service 
property  should  be  somewhat  greater  than  those  of  ordinary  safe  in- 
vestments, reference  may  again  be  had  to  the  case  of  an  owner  of  a 
public  service  property  who  invests  only  borrowed  money.  If  he 
receives  only  such  interest  on  the  investment  as  he  must  pay  to  the 
bank,  he  will  have  rendered  a  service  without  compensation,  except 
such  as  he  may  be  allowed  in  salaries,  under  operating  expenses.     In 


THE  APPRAISAL  0¥  PUBLIC   SERVICE  PROPERTIES  817 

such  case,  it  would  be  a  proper  business  arrangement  to  compensate 
him  for  the  risk  of  loss  which  he  assumes,  and  for  his  management, 
and  to  make  this  compensation  in  some  measure  proportional  to  the 
net  earnings.  If  the  owner  in  the  cited  case  is  a  stock  company,  this 
compensation  will  be  the  only  element  giving  value  to  the  capital 
stock  of  the  company. 

The  Appraisal  at  Cost  of.  Reproduction. 

The  objection  may  be  made  that,  in  the  practical  application  of 
these  principles,  the  capital  properly  invested  cannot  always  be  de- 
termined with  sufficient  accuracy.  ^^      , 

It  is  reasonable  to  expect  that,  under  good  and  intelligent  direc- 
tion, and  competent  expert  advice,  every  dollar  invested  in  a  public 
service  property  will  have  been  properly  expended.  Under  less  able 
management,  there  may  be  a  waste  of  capital,  and  the  works,  when 
completed,  will  then  have  cost  more  than  they  should.  The  book 
accounts,  therefore,  cannot  be  accepted  as  conclusive  evidence,  even 
when  it  can  be  shown  that  the  cost  account  has  been  properly  kept. 
What  is  wanted  is  a  method  or  plan  of  valuation  which  can  be  applied 
under  all  circumstances  in  perfect  fairness  to  both  the  owner  of  a 
property  and  to  the  ratepayer.  There  appears  to  be  none  better  than 
that  of  estimating  the  capital,  properly  invested,  by  an  appraisal  of 
the  public  service  property  at  cost  of  reproduction,  item  for  item, 
using,  however,  as  a  basis  for  appraisal,  not  the  prices  of  labor  and 
material  which  prevail  on  any  particular  day,  but  the  prices  which 
represent  averages  for  some  considerable  time  in  the  past. 

Under  this  method  of  appraisal,  which  is  recommended  as  fair  in 
estimating  capital  reasonably  and  properly  invested,  only  properties  in 
use  are  to  be  included  in  the  appraisal,  and  under  it  the  owner  who 
has  built  with  intelligence  and  economy  finds  himself  liberally  treated, 
while  the  owner  who  has  built  wastefully  and  has  incurred  useless  ex- 
penditures is  made  to  bear  the  penalty  of  his  wastefulness.  ^^■ 

Increase  in  value  not  represented  by  a  direct  investment  of  capital, 
as  in  the  case  of  an  appreciation  of  the  value  of  real  estate,  may 
properly  be  regarded  in  the  light  of  earnings  when  regulating  rates. 
Such  appreciation  of  value  may  also  result  from  other  causes,  as  in 
the  case  of  an  advance  in  the  prices  of  material  and  labor,  which  would 
make  the  reproduction  of  a  plant  cost  more  than  has  actually  been 


818  THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES 

invested  in  it.  On  the  other  hand,  there  may  be  a  decrease  in  value 
due  to  reduced  prices  of  material  or  labor  and  the  like.  These  changes 
are  generally  gradual  and,  when  treated  as  income,  or  as  expense,  and 
distributed  over  a  series  of  years,  usually  affect  the  general  result  but 
slightly. 

In  many  cases,  not  only  the  increase  in  the  value  of  real  estate  is 
small,  but  also  the  proportion  of  its  value  to  the  entire  value  of  a 
property.  In  such  cases,  if  there  is  uncertainty  about  first  cost  plus 
the  cost  of  improvements,  such  as  grading,  filling,  bulkheading,  street 
and  sevper  work,  the  error  made  in  ignoring  the  effect  of  a  change  in 
the  value  of  the  real  estate  will  be  small.  A  doubling  of  value  in  40 
years,  for  example,  is  equivalent  to  a  rate  of  increase  of  0.52%  per 
year  of  the  value  at  the  end  of  the  40-year  period.  A  doubling  of 
value  in  20  years  is  equivalent  to  a  rate  of  increase  of  1.68%  per 
year  of  the  value  at  the  end  of  the  20-year  period. 

These  percentages,  if  the  real  estate  represents  10%  of  the  total 
appraisal,  would  appear  in  the  earnings  as  0.17%  and  0.05%  per 
annum  of  the  total  appraisal;  but,  when  appreciation  of  value  is 
treated  as  earnings,  then  that  portion  of  the  earnings  available  for 
distribution  is  less  than  it  would  otherwise  be,  and  the  appreciation 
becomes  in  fact  a  reinvestment  of  earnings,  and  should  be  properly 
taken  into  account  in  making  an  appraisal  of  invested  capital. 

Thus,  in  the  case  of  a  property  which  has  appreciated  in  value 
100%  in  40  years,  if  this  appreciation  has  been  the  same  in  amount 
each  year,  and  if  it  could  have  been  determined  in  advance,  there 
would  have  been  entered  into  the  calculation  earnings  by  appreciation 
gradually  decreasing  as  the  property  increased  in  value  from  1.05  to 
0.52%  per  annum.  The  rate  of  interest  to  be  earned  and  distributed 
would  have  been  decreased  by  these  amounts.  An  appraisal  at  any 
time  would  then  have  taken  the  properties  into  account  at  their  ap- 
preciated value. 

,,In  practical  application  of  such  a  principle,  difficulty  arises  in  de-, 
termining  what  allowance  to  make  for  the  possible  annual  appreciation. . 
No  general  rule  can  be  laid  down  for  this  determination.  It  will  prob- 
ably be  found  that  in  most  cases,  in  view  of  the  small  rate  of  appreci- 
ation, offset  as  it  may  be  by  losses  and  by  depreciation  not  otherwise 
taken  iij|;o  apcount, ,  tlai^  appreciation  should  go  to  the  owner  of  the 


THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES  819 

property  as  a  more  or  less  indeterminate  part  of  the  profit  to  which 
he  is  entitled. 

Unless,  therefore,  there  is  good  reason  for  taking  into  account  the 
appreciation  or  the  depreciation  in  the  value  of  real  estate  as  an 
addition  to  or  a  deduction  from  earnings,  this  element  may  be  neglected. 
This  is  also  true  of  all  that  portion  of  the  plant  which  has  increased 
in  value  by  reason  of  an  advance  in  the  cost  of  labor  and  materials, 
in  case  the  appraisal  is  based  on  the  estimated  cost  of  reproduction, 
as  explained,  because,  in  that  event,  the  appraisal,  being  based  on 
prices  as  they  have  prevailed  during  considerable  time  periods,  will 
ordinarily  show  only  moderate  and  gradual  changes  of  value. 

Disadvantage  of  Annual  Eate  Eegulation. 

In  California  the  law  requires  that  the  water  rates,  to  be  charged 
by  public  service  corporations  which  supply  water  to  the  inhabitants 
of  cities  and  towns,  shall  be  fixed  annually  by  the  proper  authority. 
This  requirement  does  not  make  for  efficient  service.  It  would  be 
better,  both  for  the  owner  of  the  public  service  property  and  for  the 
ratepayer,  to  have  rates  regulated  with  less  frequency.  A  5-year 
interval  would  probably  be  about  right.  The  certainty  that  an  accept- 
able rate  will  prevail  for  at  least  a  5-year  period  would  be  an  induce- 
ment to  the  public  service  corporations  to  render  satisfactory  service. 
Extensions  would  be  made  more  willingly,  and  the  needs  of  the  rate- 
payer would  be  more  likely  to  receive  proper  consideration  than  under 
the  prevailing  system  of  annual  rate  regulation,  which  involves  in 
constant  uncertainty  business  relating  to  the  immediate  future.  The 
owner  of  the  plant,  knowing  that  each  year  his  profit  may  be  cut  off 
by  an  inadequate  rate  limit,  hesitates  to  make  any  investment  beyond 
what  may  be  imperatively  demanded,  with  the  result  that  the  service 
becomes  unsatisfactory  or  inadequate. 

The  Appraisal  of  the  Investment. 

It  has  been  made  clear  in  the  foregoing  that  a  valuation  of  the 
purely  physical  elements  of  a  public  service  property  (depreciation 
deducted),  coupled  with  an  allowance  of  amortization  computed  for 
the  full  expectancy,  as  is  frequently  done,  would  be  inadequate  as  a 
basis  for  rate  regulation.  This  fact  is  generally  recognized  by  en- 
gineers who  are  called  on  to  make  appraisals  for  such  purposes,  and 


830  THE  APPKAISAL  OP  PUBLIC  SERVICE  PROPERTIES 

no  doubt  the  amounts  added  as  intangible  values  are  sometimes  in- 
tended to  make  good  such  deficiency,  at  least  in  part,  even  when  the 
appraiser  does  not  know  why  his  appraisal  is  inadequate. 

The  necessity  in  such  cases  for  the  addition  of  something  to  the 
value  of  the  purely  physical  elements  of  a  public  service  property  un- 
doubtedly exists;  but  on  the  method  of  determining  the  amount  of  the 
addition,  there  has  not  heretofore  been  agreement.  This  is  due  to  the 
imperfect  analysis  which  has  been  made  of  such  investments,  from  the 
business  man's  standpoint,  and  to  the  ruling  of  the  Courts,  which  hold 
that  owners  of  public  service  properties  are  entitled  to  a  fair  return 
on  the  "value"  of  such  properties. 

If  it  be  found  that  the  ruling  of  the  Courts  is  not  subject  to  modi- 
fication, or,  in  other  words,  that  appraisals  must  be  "value,"  as  "value" 
would  be  determined  by  a  purchaser,  that  is  to  say,  for  the  tangible 
elements  in  most  cases,  cost  or  cost  of  replacement  less  depreciation, 
or  something  practically  equivalent  thereto,  then  the  appraisers  mak- 
ing the  valuation,  who  adhere  to  the  method  of  computing  amortization 
on  the  full  expectancy,  will  be  constrained  to  find  intangible  values 
in  one  form  or  another  which  will  swell  the  appraisal  to  where  they 
would  like  to  see  it  for  rate-regulation  purposes,  that  is,  about,  or  some-' 
what  above,  the  amount  of  capital  reasonably  and  properly  invested. 

Of  course,  a  special  franchise  granting  excessive  returns  is  out  of 
consideration  in  this  statement.  In  such  a  case,  the  intangible  values 
are  real  values  determinable  by  a  capitalization  of  earnings  and  a 
subtraction  of  the  value  of  the  tangible  parts  of  the  property. 

It  follows,  too,  that  ordinarily  it  makes  very  little  difference  whether 
the  intangible  value  is  called  "going  concern,"  or  "franchise,"  nor  how 
it  is  arrived  at,  nor  in  what  proportion  it  is  apportioned  to  these  two 
classes  of  value,  nor  whether  a  part  thereof  be  otherwise  designated, 
as  for  example,  "adaptation  and  solidification  of  roadbed,"  as  was 
done  in  a  recent  valuation  of  the  railroads  in  Minnesota. 

After  all  has  been  said,  it  will  be  found  true  that  the  adoption  of  the 
method  of  valuation  for  rate-regulation  purposes  at  the  investment 
without  deducting  depreciation  (as  herein  advocated)  will  be  always  ap-> 
plicable,  and,  if  properly  applied,  will  protect  the  interests  of  both 
owner  and  ratepayer.  It  has  a  distinct  advantage  over  other  methods, 
which  are  involved  in  more  or  less  obscurity  and  cannot  be  standardized. 
It  will  be  resisted  by  certain  corporations,  the  values  of  whose  prop- 


THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES  831 

erties,  based  on  earning  power,  have  been  greatly  inflated,  because 
thereby  the  facts  showing  the  relation  between  net  earnings  and  the 
capital  properly  invested  in  any  enterprise  are  made  apparent.  It 
will  be  welcomed  by  the  ratepayer  and  by  all  boards  or  commissions 
charged  with  regulating  rates,  and  if  generally  adopted,  will  lead 
ultimately  to  a  careful  analysis  of  earnings  by  all  owners  of  public 
service  properties,  in  order  that  actual  net  earnings  may  be  determined 
correctly.  The  relation  of  net  earnings  to  the  properly  invested  capital 
will  always  remain  the  most  important  factor  to  be  weighed,  when  rates 
are  to  be  regulated. 

The  excess  of  these  earnings  over  the  earnings  which  would  repre- 
sent a  return  on  ordinary  safe  investments  are  the  reward  which  the 
owner  receives,  as  has  been  stated,  for  his  management  of  the  property 
and  for  assuming  risks.  By  reason  of  the  fact  that  the  replacement 
or  amortization  requirement  is  necessarily  more  or  less  conjectural, 
the  prospective  net  earnings  cannot  ordinarily  be  estimated  closely. 
This  is  an  additional  reason  why  the  rate  of  return  should  be  made 
liberal.  Any  addition  to  the  rate  of  return  is  then  a  purely  arbitrary 
addition,  and  this  addition  capitalized,  if  there  is  certainty  that  it  will 
be  earned,  is  the  real  basis  for  the  intangible  values  as  they  would  be 
taken  into  consideration  by  a  purchaser. 

Of  course,  the  proceeding  can  be  reversed,  and  an  arbitrary  addition 
can  be  made  to  the  appraisal,  to  which  the  rate  of  return  is  then 
applied  in  estimating  what  the  earnings  should  be.  It  makes  no  dif- 
ference, in  the  ultimate  result,  at  which  end  the  addition  is  made,  and 
the  appraiser  in  this  matter  may  follow  his  own  inclination. 

Recent  Court  Decisions. 

"■  The  United  States  Supreme  Court,  in  Knoxville  vs.  Knoxville 
Water  Company,*  says : 

"The  first  fact  essential  to  the  conclusion  of  the  court  below  is 
the  valuation  of  the  property  devoted  to  the  public  uses,  upon  which 
the  company  is  entitled  to  earn  a  return.  That  valuation  ($608,000) 
must  now  be  considered.  It  was  made  up  by  adding  to  the  appraise- 
ment, in  minute  detail  of  all  the  tangible  property,  the  sum  of  $10,000 
for  'organization,  promotion,  etc.,'  and  $60,000  for  'going  concern.' 
The  latter  sum  we  understand  to  be  an  expression  of  the  added  value 
of  the  plant  as  a  whole  over  the  sum  of  the  values  of  its  component 

*  United  States  Reports,  Vol.  212,  p.  9.  a.  .ivU  r 


832  THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES 

parts,  which  is  attached  to  it  because  it  is  in  active  and  successful 
operation  and  earning  a  return.  We  express  no  opinion  as  to  the 
propriety  of  including  these  two  items  in  the  valuation  of  the  plant, 
for  the  purpose  for  which  it  is  valued  in  this  case,  but  leave  that 
question  to  be  considered  when  it  necessarily  arises.  We  assume,  with- 
out deciding,  that  these  items  were  properly  added  in  this  case.  The 
value  of  the  tangible  property  found  by  the  master  is,  of  course, 
$608,000  lessened  by  $70,000,  the  value  attributed  to  the  intangible 
property,  making  $538,000.  This  valuation  was  determined  by  the 
master  by  ascertaining  what  it  would  cost,  at  the  date  of  the  ordi- 
nance, to  reproduce  the  existing  plant  as  a  new  plant.  The  cost  of 
reproduction  is  one  way  of  ascertaining  the  present  value  of  a  plant 
like  that  of  a  water  company,  but  that  test  would  lead  to  obviously 
incorrect  results,  if  the  cost  of  reproduction  is  not  diminished  by  the 
depreciation  which  has  come  from  age  and  use. 

*"The  cost  of  reproduction  is  not  always  a  fair  measure  of  the 
present  value  of  a  plant  which  has  been  in  use  for  many  years.  The 
items  composing  the  plant  depreciate  in  value  from  year  to  year  in  a 
varying  degree.  Some  pieces  of  property,  like  real  estate,  for  instance, 
depreciate  not  at  all,  and  sometimes,  on  the  other  hand,  appreciate. 
But  the  reservoirs,  the  mains,  the  service  pipes,  structures  upon  real 
estate,  stand-pipes,  pumps,  boilers,  meters,  tools,  and  appliances  of 
every  kind,  begin  to  depreciate  with  more  or  less  rapidity  from  the 
moment  of  their  first  use.  It  is  not  easy  to  fix  at  any  given  time  the 
amount  of  depreciation  of  a  plant  whose  component  parts  are  of 
different  ages  with  different  expectations  of  life.  But  it  is  clear  that 
some  substantial  allowance  for  depreciation  ought  to  have  been  made 

in  this  case." 

******* 

t"A  water  plant,  with  all  its  additions,  begins  to  depreciate  in 
value  from  the  moment  of  its  use.  Before  coming  to  the  question  of 
profit  at  all,  the  company  is  entitled  to  earn  a  suificient  sum  annually 
to  provide  not  only  for  current  repairs  but  for  making  good  the 
depreciation  and  replacing  the  parts  of  the  property  when  they  come 
to  the  end  of  their  life.  The  company  is  not  bound  to  see  its  property 
gradually  waste,  without  making  provision  out  of  earnings  for  its 
replacement.  It  is  entitled  to  see  that  from  earnings  the  value  of  the 
property  invested  is  kept  unimpaired,  so  that  at  the  end  of  any  given 
term  of  years  the  original  investment  remains  as  it  was  at  the  begin- 
ning. It  is  not  only  the  right  of  the  company  to  make  such  a  pro- 
vision, but  it  is  its  duty  to  its  bond  and  stockholders,  and,  in  the 
case  of  a  public  service  corporation,  at  least,  its  plain  duty  to  the 
public.     If  a  different  course  were  pursued  the  only  method  of  pro- 

•  Loc.  cit.,  p.  10. 
t  Loc.  cit.,  p.  18. 


THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES  823 

viding  for  replacement  of  property  which  has  ceased  to  be  useful 
would  be  the  investment  of  new  capital  and  the  issue  of  new  bonds  or 
stocks.  This  course  would  lead  to  a  constantly  increasing  variance 
between  present  value  and  bond  and  stock  capitalization — a  tendency 
which  would  inevitably  lead  to  disaster  either  to  the  stockholders  or  to 
the  public,  or  both.  If,  however,  a  company  fails  to  perform  this 
plain  duty  and  to  exact  sufficient  returns  to  keep  the  investment  un- 
impaired, whether  this  is  the  result  of  unwarranted  dividends  upon 
over  issues  of  securities,  or  of  omission  to  exact  proper  prices  for  the 
output,  the  fault  is  its  own.  When,  therefore,  a  public  regulation 
of  its  prices  comes  under  question,  the  true  value  of  the  property 
then  employed  for  the  purpose  of  earning  a  return  cannot  be  enhanced 
by  a  consideration  of  the  errors  of  the  management  which  have  been 
committed  in  the  past." 

"After  the  company  had  closed  its  case  the  city  imdertook  to 
determine  the  present  value  of  the  company's  property  by  the  plain 
method  of  ascertaining  the  cost  of  reproduction,  diminished  by  depre- 
ciation. In  its  case  in  rebuttal,  the  company  followed  the  same 
method,  though  the  results  differed  largely,  and,  as  we  have  seen, 
no  proper  allowance  for  depreciation  was  made." 

The  United  States  Supreme  Court,  in  Willcox  et  dl.,  constituting 
the  Public  Service  Commission  of  New  York,  vs.  Consolidated  Gas 
Company,  says:* 

"And  we  concur  with  the  court  below  in  holding  that  the  value  of 
the  property  is  to  be  determined  as  of  the  time  when  the  inquiry  is 
made  regarding  the  rates.  If  the  property,  which  legally  enters  into 
the  consideration  of  the  question  of  rates,  has  increased  in  value  since 
it  was  acquired,  the  company  is  entitled  to  the  benefit  of  such  increase. 
This  is,  at  any  rate,  the  general  rule.  We  do  not  say  there  may  not 
possibly  be  an  exception  to  it,  where  the  property  may  have  increased 
so  enormously  in  value  as  to  render  a  rate  permitting  a  reasonable 
return  upon  such  increased  value  unjust  to  the  public.  How  such 
facts  should  be  treated  is  not  a  question  now  before  us,  as  this  case 
does  not  present  it.  We  refer  to  the  matter  only  for  the  purpose  of 
stating  that  the  decision  herein  does  not  prevent  an  inquiry  into  the 
question  when,  if  ever,  it  should  be  necessarily  presented." 

In  the  same  case,  the  United  States  Supreme  Court  holds  that  a 
valuation  of  $12  000  000  for  the  franchise,  to  be  added  to  a  valuation 
of  $47  000  000  for  physical  properties,  is  excessive. 

This  value  was  arrived  at,  by  the  lower  court,  by  assuming  a  con- 
stancy of  relation  between  the  value  of  the  franchise  and  the  value  of  the 

*  United  States  Reports,  Vol.  218,  p.  52. 


834  THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES 

tangible  property.  The  franchise  value  had  been  fixed  in  1884,  by 
agreement  of  the  companies  which  consolidated,  at  $7  781  000.  This 
valuation  received  some  sanction  or  endorsement  by  a  legislative 
committee,  which  investigated  the  consolidation  in  1885,  and  expressed 
the  opinion  that  this  valuation  of  the  franchise  was  not  more  than  its 
fair  value. 

At  the  time  of  the  consolidation  the  physical  properties  were 
valued  at  $30  000  000;  the  accepted  value  of  the  franchise  at  that 
time,  therefore,  was  26%  of  the  value  of  the  tangible  properties. 
•  :  By  applying  26%  to  the  increased  valuation  in  1906  of  the  tangible 
properties,  or  to  $47  000  000,  the  lower  court  reached  the  conclusion 
that  the  franchise  value  had  increased  to  more  than  $12  000  000,  the 
value  disapproved  by  the  Supreme  Court.     The  Court  says:* 

"But  although  the  State  ought,  for  these  reasons,  to  be  bound  to 
recognize  the  value  agreed  upon  in  1884  as  part  of  the  property  upon 
which  a  reasonable  return  can  be  demanded,  we  do  not  think  an 
increase  in  that  valuation  ought  to  be  allowed  upon  the  theory  sug- 
gested by  the  court  below.  Because  the  amount  of  gas  supplied  has 
increased  to  the  extent  stated,  and  the  other  and  tangible  property  of 
the  corporations  has  increased  so  largely  in  value,  is  not,  as  it  seems 
to  us,  any  reason  for  attributing  a  like  proportional  increase  in  the 
value  of  the  franchises. 

"Real  estate  may  have  increased  in  value  very  largely,  as  also  the 
personal  property,  without  any  necessary  increase  in  the  value  of  the 
franchises.  Its  past  value  was  founded  upon  the  opportunity  of  obtain- 
ing these  enormous  and  excessive  returns  upon  the  property  of  the 
company,  without  legislative  interference  with  the  price  for  the  supply 
of  gas,  but  that  immunity  for  the  future  was,  of  course,  uncertain, 
and  the  moment  it  ceased  and  the  legislature  reduced  the  earnings  to 
a  reasonable  sum  the  great  value  of  the  franchises  would  be  at  once 
unfavorably  affected,  but  how  much  so  it  is  not  possible  for  us  now  to 
see.    The  value  would  most  certainly  not  increase. 

"What  has  been  said  herein  regarding  the  value  of  the  franchises 
in  this  case  has  been  necessarily  founded  upon  its  own  peculiar  facts, 
and  the  decision  thereon  can  form  no  precedent  in  regard  to  the 
valuation  of  franchises  generally,  where  the  facts  are  not  similar  to 
those  in  the  case  before  us.  We  simply  accept  the  sum  named  as  the 
value  Tmder  the  circumstances  stated." 

The  Supreme  Court,  in  these  recent  opinions,  does  not  refer  to  the 

method  used  in  estimating  the  depreciation  or  amortization  increment 

__ iife 

*  Loc.  cit.,  pp.  47  and  48.  — 


THE  APPEAISAL  OP  PUBLIC  SERVICE  PROPERTIES  825 

which  must  have  entered  into  the  calculation  of  net  return.  If  this 
was  properly  determined  in  the  Knoxville  case  on  the  basis  of  the  re- 
maining useful  life  of  the  several  parts  of  the  water-works,  then  the 
opinion  of  the  Court  relating  to  the  valuation  in  that  case  is  emi- 
nently proper;  but  the  statement  of  facts  in  connection  with  this 
point  is  not  clear.  Neither  does  the  Court  have  anything  to  say  about 
it.  The  Court  no  doubt  assumed  that  the  method  of  computation 
was  a  correct  one.  In  other  words,  if  error  was  committed  at  all  it 
was  not  the  error  of  the  Court. 

It  may  be  assumed,  therefore,  that  the  decision  was  rendered  just 
as  it  would  have  been  if  amortization  had  been  correctly  determined 
(as  it  may  have  been),  and  as  far  as  the  ultimate  result  is  concerned, 
the  decision  of  the  Court  is  in  accord  with  the  principles  which  have 
herein  been  noted;  but,  for  the  sake  of  standardizing  and  simplifying 
the  method  of  arriving  at  the  desired  result,  the  Supreme  Court  might 
with  propriety,  when  opportunity  arises,  qualify  the  opinion  expressed 
in  the  Knoxville  case  so  that  all  questions  of  the  permissibility,  either 
to  make  the  appraisal  of  value  for  rate-fixing  purposes  with  deprecia- 
tion deducted,  or,  as  an  alternative,  to  make  the  appraisal  a  fair 
appraisal  of  the  amount  of  invested  capital,  using  in  each  case  the 
proper  method  of  computing  the  amortization  annuity,  will  be  set 
at  rest. 

Comparison  of  Various  Methods  of  Computing  Interest 
r  AND  Amortization. 

To  make  it  clear  that  the  two  methods  of  valuation  for  rate- 
fixing  purposes  lead  to  identical  results,  a  pipe  line  of  mature  age  may 
again  be  used  for  illustration,  and  reference  may  also  be  had  to  the 
case  of  the  steamboat  already  cited.  The  expectancy  of  the  pipe 
line  is  40  years;  it  has  been  constructed  progressively  one-fortieth 
each  year.  There  will  be  one-fortieth  of  the  pipe  40  years  old.  This 
has  served  its  time  and  is  of  no  value.  Another  fortieth  has  served 
39  years,  and  its  remaining  value  (after  deducting  the  amount  in  the 
amortization  fund  due  to  this  fortieth)  will  be  4.8%  of  the  cost  of 
replacing  it.  Another  fortieth,  38  years  old,  will  have  a  depreciated 
value  of  9.5%,  and  so  on.  The  last  fortieth,  being  new,  will  have  full 
value.  The  average  value,  as  has  already  been  stated,  will  be  63.8%, 
or  $63.80  for  each  $100  of  the  total  investment.     The  remaining  life 


826  THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES 

which  must  be  assumed  for  an  equivalent  unit  of  this  value  is  18.0 
years. 

The  computation,  on  the  theory  of  valuation  approved  by  the  U.  S. 
Supreme  Court,  will  now  be  as  follows: 

Depreciated  value  of  the  pipe  line  for  each  $100  of 

the    investment $63.80 

Amortization  increment  to  be  applied  annually,  which  will 
amount  to  $63.80  in  the  remaining  18.0  years  at  4  per 
cent $2.50 

Net  earnings   on  $63.80   at  the   assumed  rate  of  4%   per 

annum  2.55 

Total  earnings  in  excess  of  operating  expenses $5.05 

The  computation,  on  the  principle  of  valuing  the  investment  with- 
out deduction  for  depreciation,  will  be  as  follows: 

The  investment  will  be $100.00 

The  amortization  increment  to  be  applied  annually,  which 

will  amount  to  $100  in  40  years  at  4%  will  be $1.05 

The  net  earnings  on  $100  of  the  investment  at  4%  will  be. .      4.00 

The  total  earnings  in  excess  of  operating  expenses,  etc. .. .    $5.05 

The  earnings,  including  amortization,  estimated  by  the  two  methods 
are  identical.  They  are  also  identical  in  the  case  of  a  single  depre- 
ciating item,  as  in  the  case  of  the  steamboat  at  10  years,  or  at  any 
other  period  of  its  life.  They  will  always  be  identical,  whether  the 
plant  is  large  or  small,  simple  or  complex. 

The  simple  method  of  making  appraisals  should,  in  the  end,  find 
general  acceptance,  and  when  the  fact  of  the  absolute  agreement  of 
this  method  with  that  laid  down  in  the  Knoxville  case  is  properly 
brought  to  the  attention  of  the  Courts,  it  may  be  expected  that  it 
will  obtain  their  approval. 

In  Table  8,  and  by  the  diagram,  Fig.  3,  the  results  of  computing 
earnings  according  to  five  different  methods  are  presented.  All 
figures  in  Table  8  apply  to  $100  of  invested  capital.  The  interest 
rate  on  safe  investments  is  taken  at  4%  per  annum.  Similar  tables 
and  diagrams  could  have  been  prepared  for  other  expectancies  than 
20  years,  and  for  other  rates  of  interest,  but  this  single  table  will 
suffice  to  make  clear  the  fundamental  principles  which  are  involved, 


THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES  827 

and  particularly  the  fact  that  the  results  by  the  simplest  method  of 
all,  No.  1,  always  coincide  exactly  with  the  results  by  Method  No.  3, 
the  latter  being  in  unquestioned  conformity  with  the  opinion  of  the 
U.  S.  Supreme  Court,  as  recently  expressed  in  the  Knoxville  case. 

The  first  method  of  computing  earnings,  as  illustrated  in  Table  8 
for  a  20-year  life  at  4%  per  annum,  as  has  been  fully  explained,  is 
based  on  a  valuation  at  all  times  at  100%  of  the  investment.  The 
amortization  fund  is  supposed  to  be  held  as  a  part  of  the  property, 
transferable  with  it,  and  the  amortization  increment  is  not  written 
off  as  depreciation.  The  several  amounts  paid  into  the  amortization 
fund  are  not  available  to  the  owner  until  replacement  is  necessary  at 
the  end  of  the  term  of  the  plant's  usefulness.  The  moment  they  are 
applied  as  a  retirement  of  capital,  it  becomes  necessary  to  compute 
amortization  for  the  remaining  value  and  the  remaining  life.  When 
this  is  done  annually,  the  result  is  as  shown  under  Method  No.  3. 

The  second  method  is  an  approximation  which  is  not  generally 
applicable.  It  is  proper  for  a  complex  plant  of  mature  age,  when  it 
can  be  shown  that  there  has  been  no  opportunity  to  accumulate  an 
amortization  fund;  when,  in  other  words,  the  allowance  for  amortiza- 
tion has  not  exceeded  the  requirement  for  replacement.  A  modifica- 
tion of  this  method  results  from  the  application  of  the  formula  for 
replacement,  as  elsewhere  noted,  to  be  used  in  the  case  of  plants  of  a 
uniform  rate  of  growth. 

The  introduction  of  the  annual  replacement  requirement  properly 
determined  by  any  method,  in  place  of  amortization,  would  make 
Method  No.  2  of  computing  earnings  generally  applicable  in  all  cases 
in  which  past  amortization  increments  have  not  exceeded  the  replace- 
ment requirements. 

The  third  method  is  that  which  literally  conforms  to  the  recent 
Supreme  Court  decisions,  already  quoted.  Depreciation  is  taken  into 
account  in  making  the  valuation,  and  amortization  is  estimated  for 
this  valuation  and  the  remaining  life.  This  agrees  absolutely  with 
Method  No.  1.  It  is  based  strictly  on  the  assumption  that  the  amor- 
tization is  synonymous  with  depreciation,  and  is  deducted  from  the 
investment  as  each  annual  increment  is  received.  The  annual,  gradu- 
ally increasing  amortization  or  depreciation  increment,  under  Method 
No.  3,  can  be  ascertained  by  formula  as  follows : 


828 


THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES 


Let  a  represent  the  amortization  annuity  for  the  full  or  original 

expectancy  (the  same  as  under  Method  No.  1).  '^  J^ 

i  represent    the    rate    of    interest    used    in    determining    the 

annuity. 
n  be  the  number  of  the  year  for  the  end  of  which  the  depre- 
ciation increment  is  to  be  estimated. 
Ai  represent  the  depreciation  increment  for  the  year,  n:  uaiiiui 
100a  r /100+K  "+i        /100  +  r 


Then:   A,.  = 


r/100-M\"+^        /100  +  K  "1 
LV     100    /        ~  V     100     /   J 


^      L  V     100    /  \     100 

For  i  =  4,  that  is,  for  an  interest  rate  of  4%,  this  will  be: 

A^  =  2.5  a  (1.04"  +  ^  —  1.04") 
For  *  =  3,  there  will  be: 

J.3  =  33.33  a  (1.03"  +  ^  —  1.03") 
For  i  =  5,  there  will  be: 

A^  =  20a  (1.05" +  ^  —  1.05") 

TABLE  8. — Methods    of    Calculating    Annual    Interest    and 
Amortization  for  an  Expectancy  of  Twenty  Years. 

Method  No.  1. 
For  each  SlOO  of  original  investment.     Interest  4  per  cent. 


VALUATIONrrlNVESTMENT   WITHOUT   DEDUCTION   FOR  DEPRECIATION. 

At  the  end  of  year. 

Amortization  Based  on  Expectancy. 

Valuation  for 
each  8100  of 
investment. 

Interest  at  4% 
per  annum. 

Annual 

amortization 

increment. 

Net  earnings, 

including 
amortization. 

b 

0 

8100.00 
100.00 
100.00 
100.00 
100.00 
100.00 
100.00 
100.00 
100.00 
100.00 
100.00 
100.00 
100.00 
100.00 
100.00 
100.00 
100.00 
100.00 
100.00 
100.00 
100.00 

84.00 
4.00 
4.00 
4.00 
4.00 
4.00 
4.00 
4.00 
4.00 
4.00 
4.0O 
4.00 
4.00 
4.00 
4.00 
4.00 
4.00 
4.00 
4.00 
4.00 
4.00 

83.38 
8.86 
8.36 
8.36 
3.36 
8.86 
3.86 
3.36 
3.36 
3.86 
8..S6 
3.36 
8.36 
8.36 
8.36 
3.86 
8.86 
3.36 
3.36 
8.S6 
3.36 

87.86 
7.36 

1 

2 

7  36 

8 

7.36 

4 

7  36 

5 

7.36 

6 

7  36 

7....... 

7.36 

g..,.....,.- 

7.36 

9.... ....!. 

7.36 

10 

7.36 

11 

7.86           '^ 

12 

7.36 

18 

7.86 

14 

7.36 

15 

7.86 

16 

7.86 

17 

7.36 

18 

7.36 

19 

7.36 

20 

7.36 

8100.00 

84.00 

83.86 

87.86 

THE  APPRAISAL  OF  PUBLIC   SERVICE  PROPERTIES 


829 


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THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES 


TABLE  8  (Continued). — Methods  of  Calculating  Annual  Interest 
AND  Amortization  for  an  Expectancy  of  Twenty  Years. 

Method  iVo.  S. 
(An  approximation  method  applicable  in  special  cases  only.) 
For  each  $100  of  original  investment.     Interest  4  per  cent. 


ValujItion=Investment  without  Deduction  fob  Depreciation. 

At  the  end  of  year. 

Amortization  by  Straight  Percentage. 

Valuation  for 
each  $100  of 
investment. 

Interest  at  4% 
per  annum. 

Annual 
amortization 
increment.* 

Net  earnings, 

including 
amortization. 

0 

$100.00 
100.00 
100.00 
100.00 
100.00 
100.00 
100.00 
100.00 
100.00 
100.00 
100.00 
100.00 
ICO.OO 
100.00 
100.00 
100.00 

$4.00 
4.00 
'    4.00 
4.00 
4.00 
4.00 
4.00 
4.00 
4.00 
4.00 
4.00 
4.00 
4.00 
4.00 
4.00 
4.00 

$5.00 
5.00 
5.00 
5.00 
5.00 
5.00 
5.00 
5.00 
5.00 
5.00 
5.00 
5.00 
5.00 
5.00 
5.00 
5.00 
6.00 
5.00 
-    5.00 
5.00 
5.00 

$9.00 
9  00 

1 

2 

9  00 

3 

9  00 

4 

9  00 

5 

9  00 

6 

9  00 

7 

9.00 

8 

9  00 

9 

9.00 

lo:.,.. 

9  00 

i^yi:. ::::.::: .:.:::: 

9.00 

12 

9.00 

13 

9.00 

14 

9.00 

15 

9.00 

16 

100.00 
ICO.OO 
100.00 
100.00 
100.00 

4.00 
4.00 
4.00 
4.00 
4.00 

9.00 

17 

9.00 

18 

9.00 

Ifl...; 

9.00 

8$., 7; 

9.00 

A  verages 

$100.00 

$4.00 

$5.00 

$9.00 

*  In  the  case  of  a  plant  of  mature  age,  made  up  of  numerous  parts,  amortization  as  here 
noted  is  the  annual  replacement  requirement. 

The  fourth  method,  based  on  a  valuation  which  takes  depreciation 
into  account  and  allows  an  annual  amortization  increment  determined 
by  the  direct  percentage  method,  has  the  serious  defect  of  requiring 
large  earnings  in  the  early  years  of  a  plant's  life  and  smaller  earnings 
toward  the  end  of  its  life.  This  defect  is  fatal  to  its  general  applica- 
tion. It  may  find  occasional  application,  however,  as  a  convenient 
method  of  approximating  the  required  earnings  in  the  case  of  com- 
plex plants  of  mature  age,  but,  even  then,  as  is  shown  by  the  line  of 
averages  in  the  table,  the  probability  is  tha,t  it  will  be  in  some  measure 
unfair  to  the  owner.  It  will  give  results  in  strict  accord  with  those  of 
Methods  Nos.  1  and  3  at  only  a  single  period  of  the  life  of  a  plant, 
as  for  example,  at  4.2  years  for  a  plant  (or  an  item)  having  a  10-year 


THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES 


831 


life;  at  8.2  years  for  a  plant  having  a  20-year  life,  and  at  14.5  years 
for  a  plant  having  a  40-year  life,  and  so  on.  : 

The  fifth  method  is  incorrect,  and  is  decidedly  unfair  to  the  owner. 
It  is  to  be  condemned  under  all  circumstances,  notwithstanding  the 
fact  that  it  gives  nearly  correct  results  in  the  early  years  of  a 
plant's  life. 


or 


f,.- 


TABLE  8  (ConUnuectj. — Methods  of  Calculating  Annual  Interest 
AND  Amortization  for  an  Expectancy  of  Twenty  Years. 

Method  No.  3. 
For  each  $100  of  original  investment.     Interest  4  per  cent. 


Valuation=Investmknt  Less  Depreciation. 

At  the  end  of  year. 

Amortization  Based  on  the  Remaining  Life. 

Valuation  for 
each  $100  of 
investment. 

Interest  at  4% 
per  annum. 

Annual 

amortization 

increment. 

Net  earnings, 

including 
amortization. 

0 

$100.00 
96.64 
93.15 
89.53 
85.94 
80.81 
77.73 
73.48 
69.06 
64.46 
59.68 
54.71 
49.54 
44.16 
38.57 
82.76 
26.71 
20.42 
13.88 
7.08 
0.00 

$4.00 
3.86 
3.73 
3.58 
3.43 
3.27 
3.11 
2.94 
2.76 
2.58 
3.89 
3.19 
1.98 
1.78 
1.54 
1.31 
1.07 
0.83 
0.56 
0.28 
0.00 

$3.36 
3.49 
3.63 
3.76 
3.93 
4.09 
4.25 
4.42 
4.60 
4.78 
4.97 
5.17 
5.38 
5.59 
5.82 
6.05 
6.29 
6.54 
6.80 
7.08 
7.36 

$7.36 
7  36 

1 

3 

7  36 

3 

7  36 

4 

7  86 

5 

7  36 

6 

7  36 

7 

7  36 

8 

7  36 

9 

7  36 

10 

7  36 

11 

7!36 

13 

7  86 

13 

7  36 

14 

7.36 

15 

7.86 

16 

7.36 

17 

7.36 

18 

7.86 

19 

7.86 

20 

7.36 

Averages 

$58.95 

$2.36 

$6.00 

$7.36 

The  averages   at  the  bottom   of  Table  8   are  the  valuations   and 


9' 


amounts  which  apply  in  the  case  of  equal  groups  of  items  of  every 
possible  age.  The  average  amortization  noted  for  Method  No.  3  is 
the  same  as  the  amount  which  would  be  estimated  by  the  straight 
percentage  method.  This  is  true  for  any  life,  not  alone  for  the  20-year 
period,  to  which  the  table  applies.  In  other  words,  when  amortization 
has  been  properly  allowed  from  the  beginning,  in  the  case  of  a  com- 
plex plant  as  described,  the  earnings  are  to  include  interest  on  the 


B3^  THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES 

remaining  investment  and  amortization  computed  by  the  straight- 
percentage  method. 

In  the  cas6  of  a  plant  made  up  of  many  parts  of  various  periods 
of  useful  life,  the  practice  is  sometimes  followed  of  estimating  depre- 
ciation for  each  group  of  parts  of  equal  life  (n  years)  at  one-nth  of 
the  remaining  book  value. 

Under  such  practice,  the  average  book  value  of  each  $100  of 
original  investment,  if  the  plant  has  mature  age  and  its  parts  are 
uniformly  distributed  to  all  possible  ages,  will  be  about  as  follows : 

In  a  group  having  a     5-year  life $67.23 

"            "             "  10    "        "    65.15 

"            "             «  20    "        "    64.15 

"            "             "  30    "        "    63.83 

"            "             «  40    "        "    63.68 

Interest  and  amortization  (in  this  case  the  assumed  depreciation) 
would  be  figured  as  follows: 

5-Year  Life: 

Interest  on  $67.23  at  4  % =  $2.69 

Amortization,  20%  of  $67.23 =  13.45 

$16.14 

Whereas  interest  plus  amortization  should  be,  at  least. . . .        22.64 

10-Year  Life: 

Interest  on  $65.15  at  4% =  $2.61 

Amortization,  10%  of  $65.15 =     6.52 

$9.18 

Whereas  interest  plus  amortization  should  be,  at  least.  . . .        12.33 

80-Year  Life: 

Interest  on  $64.15  at  4% =  $2.57 

Amortization,  5%   on  $64.16 =     3.21 

$5.78 

Whereas  interest  plus  amortization  should  be,  at  least. . . .  7.36 

Jfi-Year  Life: 

Interest  on  $63.68  at  4% =  $2.55 

Amortization,  2.5%  on  $63.68 =     1.59 

$4.14 

Whereas  interest  plus  amortization  should  be,  at  least.  ..  .  5.05 


THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES 


833 


TABLE  8  (Continued). — Methods  of  Calculating  Annual  Interest 
AND  Amortization  for  an  Expectancy  of  Twenty  Years. 

Method  No.  4. 
For  each  $100  of  original  investment.     Interest  4  per  cent. 


VALT' 

ATioN=  Investment  Less  Depreciation. 

At  the  end  of 
year. 

Amorlization  Based  on  Straight  Percentage. 

Valuation  for 
each  $100  of 
investment. 

Interest 

at  4% 

per  annum. 

Annual              Net  earnings, 
amortization    i       including 
increment.          amortization. 

0 

$100.00 
95.00 
90.00 
85.00 
80.00 
75.00 
70.00 
65.00 
60.00 
55.00 
50.00 
45.00 
40.00 
35.00 
30.00 
25.00 
20.00 
15.00 
10.00 
5.00 
0.00 

$4.00 
8.80 
3.60 
3.40 
3.20 
3.00 
2.80 
2.60 
2.40 
2.20 
2.00 
1.80 
1.60 
1.40 
1.20 
1.00 
0.80 
0.60 
0.40 
0.20 
0.00 

$5.00 
5.00 
5.00 
5.00 
5.00 
5.00 
5.00 
5.00 
5.00 
5.00 
5.00 
5.00 
5.00 
5.00 
5.00 
5.00 
5.00 

$9.00 

1  

8.80 

2 

8.60 

3 

8.40 

4  

8.20 

5 

8.00 

6  

7.80 

7 

7.60 

8  

7.40 

9 

7.30 

10 

7.00 

11  

6.80 

1-i 

6.60 

i;?     

6.40 

14 

6.20 

15  

6.(X) 

16 

5.80 

17 

5.00            i               5.60 

18  

5.00            :               5.40 

19 

5.00            1               5.20 

20  

5.00            1               5.00 

Averages 

$50.00 

$2.00 

$5.00            '             $7.00 

The  amortization  increment  computed  by  Method  No.  5  is  clearly 
inadequate. 

It  is  now  possible  to  prepare  tables  for  various  expectancies  which 
will  show  the  required  earnings  (not  including  any  allowance  for 
management),  including  amortization,  computed  by  methods  which 
have  been  shown  to  be  proper. 

Table  9  is  based  on  Method  No.  1  (Table  8).  The  property  is 
appraised  for  rate-fixing  purposes  at  100%  of  the  investment,  and  the 
original  expectancy  is  made  the  basis  of  computing  the  annual  amor- 
tization increment.  In  this  table  the  interest  column  is  not,  strictly 
speaking,  based  on  the  true  value  of  the  property,  neither  is  the 
amortization  annuity  noted  in  the  following  column  in  strict  con- 
formity with  the  growth  of  an  annuity  fund,  but  the  sum  of  the  two 
columns  is  the  correct  sum  of  these  two  increments  which  are  to  be 


834 


THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES 


covered  by  the  earnings.     (The  same  rate  of  interest  is  supposed  to 
apply  throughout.) 

TABLE  8  (Gdntinued). — Methods  of  Calculating  Annual  Interest 
AND  Amortization  for  an  Expectancy  of  Twenty  Years. 

Method  No.  5. 

(Always  erroneous.) 

For  each  SlOO  of  original  iuvestment.      Interest  4  per  cent. 


Valu^ 

iTiON  =  Investment  Less  Depbeci 

ATION. 

At  the  end  of  year. 

Amortization  Based  on  the  Full  Expectancy. 

Valuation 

for  each  .SI  00  of 

investment. 

Interest 

at4J^ 

per  annum. 

Annual 

amortization 

increment. 

Net  earnings, 

including 
amortization. 

0 

8100.00 
96.04 
98.15 
89.52 
85.74 
81.81 
77.73 
73.48 
69.06 
64.46 
59.68 
54.71 
49.54 
44.16 
88.57 
82.76 
20.71 

$4.00 
3.86 
3.73 
3.58 
3.43 
8.27 
8.11 
2.94 
2.76 
2.58 
2.39 
2.19 
1.98 
1.78 
1..54 
1.81 
1.07 

$3.86 
3.36 
3.36 
3.86 
8.36 
3.36 
3.80 
3.86 
8.36 
3.36 
3.80 
8.30 
8.36 
8.86 
8.86 
3.36 
8.36 
3.86 
8.3'. 
8.. SO 
a  sfi 

$7.36 
7  22 

1 

2 

7  09 

8 

6  94 

4 

6  79 

5 

6  51 

6 

6.47 

7 

6  30 

8 

6A4 

9 

5.94 

10 

5  "5 

11 

5  55 

12 

5  34 

18 

5.14 

14 

4.90 

16 

4.67 

16 

4.43 

17 

18 

20.42 

13.88 

7.08 

0.00 

0.82 
0.56 
0.28 
0.00 

4.18 
3.92 

19 

3.64 

20 

3.36 

Averages 

$58.99                          K2..36                          S3. ,36 

$5.72 

Table  10  and  Fig.  4  are  based  on  Method  No.  3  (Table  8).  The 
property  is  appraised  with  deduction  of  depreciation.  The  appraisal 
thus  made  will,  in  the  case  of  a  property  of  mature  age  and  a  suf- 
ficiently large  number  of  parts,  conform  with  the  figures  in  the  "Re- 
maining value"  column.  The  annual  amortization  increment  is  com- 
puted by  the  use  of  amortization  tables,  from  the  remaining  life  and 
the  remaining  value.  The  results  presented  in  this  table  are  obtained 
by  methods  of  valuation  in  accord  with  the  recent  decision  of  the 
TJ.  S.  Supreme  Court;  and  there  is  perfect  agreement  in  the  ultimate 
result  with  those  obtained  by  Method  No.  1. 


THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES 


835 


Table  11  is  for  iise  when  a  plant  has  attained  mature  age  and  no 
part  of  the  invested  capital  has  been  repaid.  The  annual  amortiza- 
tion increment  is  here  equal  to  the  annual  replacement  requirement. 
It  is  not,  therefore,  to  be  applied  as  a  reduction  of  the  investment. 
If,  however,  there  has  been  a  partial  repayment  of  capital  invested, 
as  in  the  case  of  aid  extended  by  bond  issues  or  otherwise,  then  the 
appraisal  should  be  correspondingly  reduced. 

All  these  tables  are  based  on  4%  per  annum,  as  the  rate  of  return 
on  ordinary  safe  investments.  The  earnings,  as  noted  in  the  tables, 
do  not  include  any  allowance  for  management,  nor  for  unusual  risk 
and  the  like,  which  are  to  be  made  in  each  case  as  circumstances  may 
warrant,  either  as  has  been  explained,  by  the  subterfuge  of  adding 
arbitrarily  assumed  intangible  values  to  the  appraisal,  or  by  making 
an  addition  direct  to  the  interest  rate  which  is  applied  to  the  appraisal. 

TABLE    9. — Interest   and    Amortization    for   Any    Plant    of 

Any  Age. 

Method  No.  1  (Table  8). 

Generally  Applicable. 

Interest  4  per  cent. 


For  each  SlOO  of  original  investment 


Expectancy,  in 
years. 

Appraisal. 

Interest. 

5 

$100 
100 
100 
100 
100 
100 
100 
100 
100 
100 
100 
100 
100 
100 

$4.00 
4.00 
4.0O 
4.00 
4.00 
4.00 
4.0(J 
4.00 
4.00 
4.00 
4.00 
1.00 
4.00 
4.00 

0 

7 

8 

9 

10 

15 

20 

25 

30 

35 

40 

45 

50 

Amortization 
annuity. 


$18.4(;3 

15.079 

lsi.661 

10.853 

9.449 

8.3^9 

4.994 

3.358 

2.401 

1.78:^ 

1.3.T8 

1.052 

0.K;i6 

0.655 


Interest  plus 
amortization. 


$23.4(5 

19.08 

lb. 66 

14.85 

13.45 

lv!.3:! 

8.99 

7.36 

6.40 

5.78 

5.36 

5.05 

4.83 

4.66 


It  is  worthy  of  note,  in  the  case  of  numerous  parts  of  the  same 
expectancy  uniformly  distributed  to  all  possible  ages,  as  will  be  seen 
by  reference  to  Table  10,  that,  when  depreciation  is  estimated  by  the 
annuity  method,  and  is  properly  deducted  from  the  invested  capital, 
under  Method  No.  3,  the  annual  amortization  or  depreciation  incre- 
ment is  the  same  as  though  determined  by  the  straight-line  method. 

The  method  of  appraisal  and  computation  of  earnings  illustrated 
in  Table  11  is  substantially  correct  for  a  plant  of  mature  age  when 


836 


THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES 


the  annual  replacement  requirement  may  be  substituted  for  the 
amortization.  It  is  not  likely  that  there  will  have  been  an  excess 
of  income  during  the  early  years  of  a  plant's  service.  The  early 
years  are  generally  lean  years,  which  are  ordinarily  expected  to 
produce  less  than  the  desired  income.  Therefore,  apart  from  excep- 
tional cases,  it  may  be  generally  assumed  that  a  plant  when  it  has 
reached  mature  age  should  be  earning  the  replacement  requirement 
in  addition  to  a  reasonable  rate  of  interest  on  the  investment. 

TABLE  10. — Interest  and  Amortization. 

Average  values  for  plants  of  numerous  parts  uniformly  distributed 
T  to  all  possible  ages. 

Method  No.  3  (Table  8). 

For  each  SlOO  of  original  investment.     Interest  4  per  cent. 


Expectancy . 


6 
6 

7, 
8. 
9 
10 
15 
20 
25 
30 
35 
411 
45 
50 


Remaining 
life  of  equiva- 
lent single 
item,  in  years. 


3.0 

3.5 

4.0 

4.5 

4.9 

5.3 

7.6 

9.9 

12.0 

14.1 

16.0 

17.9 

19.7 

21.5 


Average 

remaining 

value. 


$61.58 
60.30 
59.38 
.^8.88 
68.45 
58.23 
58.18 
f.8.95 
60.03 
61.25 
62.53 
63.80 
t)5.10 
66.38 


Interest  on 

remaining 

value. 


$2,463 
2.412 
2.375 
2.353 
2.33S 
2.329 
2.327 
8.358 
2.401 
2.450 
2.501 
2.552 
2.604 
2.655 


Amortization 

annuity  for 

remaining 

life. 


$20,000 

16.667 

14.286 

12.500 

11.111 

10.000 

6.667 

5.000 

4.000 

3.383 

2.857 

2.500 

2.222 

2.U00 


Interest  plus 
amortization. 


$22.46 

19.08 

16.66 

14.85 

1.3.45 

12.88 

8.99 

7.36 

6.40 

5.78 

5.36 

5.05 

4.83 

4.66 


If,  however,  it  can  be  shown  that  the  investment  has  been  cut  down 
by  excessive  earnings  or  by  a  direct  repayment  of  capital,  as  in  the 
case  of  municipal  or  State  aid  by  contribution  of  funds  to  the  owner, 
then  the  interest  rate  should  be  applied  only  to  the  remaining 
investment. 

Method  No,  4,  Tables  8  and  11,  is  practically  equivalent  to  a  com- 
putation of  the  replacement  requirement  for  inclusion  in  the  earnings. 
When,  however,  a  new  plant  of  numerous  parts  is  in  question,  all  the 
expectancies  of  which  are  n  years,  it  would  be  better  to  grade  the 
replacement  increment  from  nothing  at  the  beginning  to  one-nth  of 
the  investment  in  the  nth  year. 


THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES 


8sr 


TABLE  11. — Interest  and  Amortization. 

For  Plants  of  Mature  Age  in  Case  that  the  Amortization  Earned  in  the 

Past  has  not  Exceeded  the  Replacement  Requirements. 

Method  No.  4.  (Table  8). 
For  each  SlOO  of  original  investment.     Interest  4  per  cent.  ' 


Expectancy. 

Appraisal. 

Interest. 

Annual  amorti- 
zation or 
replacement 
requirement. 

Interest  plus 
amortization. 

5 

$100 
100 
100 
100 
100 
100 
100 
100 
100 
100 
100 
100 
100 
100 

$4.00 
4.00 
4.00 
4.00 
4.00 
4.00 
4.00 
4.00 
4.00 
4.00 
4.00 
4.00 
4.00 
4.00 

$20.00 

16.67 

14.29 

12.50 

11.11 

10.00 

6.67 

5.00 

4.00 

3. as 

2.86 
2.50 
2.22 

2.00 

$24.00 

6 

20.67 

7 

18.29 

8 

16.50 

9 

15.11 

10 

14.00 

15 

10.67 

20 

9.00 

25 

8.00 

30 

7.33 

35 

6.86 

40 

6.50 

45 

6.23 

50 

6.00 

The  practice  has  heretofore  been  so  general  of  assuming  that  the 
amortization  annuity,  based  on  the  original  expectancy,  was  an  ade- 
quate amortization  allowance,  that  there  may  be  cases  in  which  such 
allowance  was  from  year  to  year  erroneously  deducted  from  the  invest-, 
ment  as  depreciation,  Method  No.  5,  Table  8.  Let  the  case  be  con- 
sidered where  this  has  been  done  for  a  plant  with  a  20-year  useful 
life.  When  this  plant  is  10  years  of  age  the  owner  will  have  received 
ten  annual  amortization  payments  of  $3.36.  These,  under  this  assump- 
tion, were  applied  to  reduce  the  capital  invested  when  he  received 
them.  At  the  10-year  period,  therefore,  there  is  a  value  of  $67.40  left 
in  the  plant  for  each  $100  of  original  investment.  The  earnings 
should  be  interest  on  this  amount  at  4%,  or  $2,70  plus  the  amortiza- 
tion for  $67.40  for  the  remaining  10  years,  or  ($67.40  X  0.0833)  = 
$5.61,  making  $8.31.  If  the  plan  of  allowing  interest  on  the  reduced 
valuation  plus  the  original  amortization  increment  of  $3.36  had  been 
followed,  the  earnings  of  ($2.70  +  $3.36)  ==  $6.06  would  be  inadequate. 


Conclusion. 

Thus  far,  no  distinction  has  been  made  between  expectancy  and 
the  actual  life.  All  computations  have  been  made  as  though  there 
were  absolute  conformity  between  the  actual  life  and  the  expectancy. 


838  THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES 

This,  however,  is  never  strictly  true,  because  some  items  of  every 
group  will  go  out  of  use  before  they  are  of  mature  age,  while  others 
will  survive  their  expectancy. 

The  amortization  annuity  estimated  for  the  actual  life  of  a  large 
number  of  items  will  not  necessarily  agree  with  the  amortization 
annuity  based  on  average  probable  life.  That  there  must  be  dis- 
agreement will  readily  be  seen  when  a  single  item  is  taken  into  con- 
sideration. This  may  be  one  of  those  doomed  to  fail  early;  or  it 
may  be  one  of  the  large  number  which  will  reach  a  mature  age; 
or  it  may  be  among  the  smaller  number  which  serves  long  after  the 
expected  age  has  been  passed.  Taking  all  probabilities  into  account, 
when  the  item  is  new,  it  will  be  found  that  the  amortization  rate 
which  should  apply  will  always  conform  to  an  actual  life  somewhat 
less  than  the  expectancy. 

It  is  not  proposed  to  follow  this  matter  further,  nor  to  attempt  a 
specific  illustration  which  would  necessarily  have  to  be  based  on  some 
assumption  relating  to  mortality  unsubstantiated  by  experience;  but 
there  may  be  found  in  this  fact  some  justification  for  making  liberal 
allowance  for  amortization  from  the  beginning  of  a  plant's  service. 

According  to  the  Court  opinions  previously  quoted,  there  is  a 
distinct  recognition  by  the  United  States  Supreme  Court  of  the 
propriety  of  including  intangible  values  in  the  appraisal  for  rate- 
regulation  purposes.  The  Court,  however,  indicates  no  method  by 
which  the  value  of  a  franchise  is  to  be  determined.  It  states  distinctly 
that  the  opinion  in  the  New  York  gas  rate  case  is  not  to  be  con- 
sidered  a  general  precedent. 

There  is  also  a  distinct  recognition  of  the  fundamental  principle 
that  the  value  of  the  investment  should  be  maintained  as  at  the  begin- 
ning. This  is  strictly  correct  if  it  is  intended  to  apply  to  the  value  of 
the  properties  as  a  business  and  not  to  the  tangible  properties  alone. 
There  is  hardly  room  to  doubt  that  this  is  the  actual  meaning  intended 
to  be  conveyed,  because  a  little  farther  on  the  Court  says  that  the 
tangible  properties  of  water-works  and  the  like  begin  to  depreciate 
on  the  day  they  go  into  use.  Such  depreciation  of  the  tangible  prop- 
erties, as  referred  to  by  the  Court,  cannot  be  offset  or  made  good  by 
any  amount  of  repair  work,  because,  to  all  intents  and  purposes,  the 
depreciated  items  may  continue  for  a  long  time  to  be  rendering  just  as 
adequate  service,   and  often  even  better  service,  than   when  first  in- 


THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES  839 

stalled.  To  be  kept  at  100%  of  the  investment,  the  appraisal  would  at 
all  times  have  to  be  the  value  of  the  physical  properties  plus  the 
amortization  fund. 

•^  The  difference  between  the  value  of  the  tangible  property  and  the 
invested  capital  might,  perhaps,  according  to  this  interpretation  of  the 
language  used  by  the  Court,  be  a  proper  measure  of  the  intangible 
values ;  but,  if  thus  measured,  they  serve  merely  as  an  excuse  for  bring- 
ing the  valuation  up  to  the  investment,  and,  in  that  event,  the  amortiza- 
tion increment  must  be  based  on  the  full  expectancy  of  the  plant. 
In  applying  such  a  principle,  account  must  be  taken  of  the  gradually 
decreasing  value  of  the  Intangible  elements.  The  steamboat  in  the  last 
year  of  its  life  would  be  valued  at  7%,  and  the  intangible  values 
appurtenant  to  the  steamboat  business  would  aggregate  93  per  cent. 
No  one  would  pay  more  than  7%  for  the  boat,  yet,  as  has  been  demon- 
strated, the  rates  may  properly  be  based  on  a  valuation  of  the  steam- 
boat business  at  100  per  cent. 

This,  of  course,  is  an  extreme  case,  but  it  illustrates  the  principle. 
Perhaps  no  Court  has  ever  been  asked  to  allow  so  large  a  proportion 
of  intangible  value.  Yet  the  principle  remains  the  same,  whether  at 
5  years  the  intangible  value  is  18%  of  the  entire  appraisal,  or  whether 
at  19  years  it  is  93%  thereof.  This  undesirable  feature  should  condemn 
the  use  of  intangible  values  to  bring  the  appraisal  up  to  the  actual 
investment. 

It  will  be  much  better  to  use  the  equivalent  and  uniformly  appli- 
cable method  of  determining  by  the  best  available  means  what  amount 
of  capital  is  properly  and  reasonably  invested.  The  attempt  to 
draw  sharply  the  line  which  separates  the  tangible  from  the  intangible 
value  should  be  discouraged. 

\w  li  it  were  customary  to  maintain  the  amortization  fund,  perhaps 
by  investment  in  outside  securities,  as  an  integral  and  inseparable 
part  of  the  property,  growing  as  depreciation  increases  and  subject  to 
transfer  with  the  property  as  a  part  thereof,  in  case  of  a  sale,  then  the 
fundamental  principle,  already  fully  explained,  that  the  appraisal  at 
all  times  should  be  at  100%  of  the  investment,  would  be  readily  un- 
derstood. It  would  then  be  clear  that  the  earnings  of  the  amortiza- 
tion fund  would  go  into  the  property  for  replacement  purposes,  and 
that  at  all  times  the  owner  would  be  entitled,  in  addition  to  such  earn- 
ings, to  a  proper  rate  of  return  on  100%  of  the  investment,  that  is 


840  THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES 

to  say,  on  the  value  remaining  in  the  physical  property  plus  the 
amortization  fund. 

The  Supreme  Court  distinctly  lays  down  the  principle  that,  as  a 
general  rule,  increase  in  value  should  go  to  the  owner  of  a  property. 
This  is  a  confirmation  of  the  views  previously  set  forth.  First,  that, 
strictly  speaking,  the  increase  should  be  treated  as  reinvested  earnings; 
second,  that,  under  the  difficulty  which  will  always  exist  of  predicting 
from  past  experience  what  the  future  may  bring,  it  will  rarely  be 
possible  to  estimate  the  future  increment  of  earnings  due  to  apprecia- 
tion with  sufficient  certainty  to  take  it  into  account  in  estimating  the 
prospective  surplus  or  revenue  over  expense,  and,  whenever  this  can- 
not be  done,  such  increase  of  value  will,  in  fact,  go,  as  the  Supreme 
Court  says  it  should,  to  the  owner;  but,  when,  as  an  exception  to  the 
rule,  which  exception  is  pointed  out  by  the  Court,  the  property  has  in- 
creased enormously  in  value,  then  the  fairness  of  taking  account  of 
the  increase  as  a  part  of  the  earnings  becomes  apparent. 

The  foregoing  is  based  throughout  on  the  assumption  that  the 
ordinary  rate  of  interest  on  safe  investments  is  alone  taken  into  account, 
and  that  any  addition  to  this  rate  will  be  made  as  a  direct  addition 
to  the  earnings  computed  at  this  ordinary  rate.  The  addition  may  be 
expressed  either  in  percentage  of  the  original  investment,  or  in  per- 
centage of  the  remaining  investment,  or  true  value,  as  ordinarily 
understood  and  as  defined  by  the  IT.  S.  Supreme  Court  in  the  Knox- 
ville  case.  The  latter  may  be  found  desirable,  when,  as  should  or- 
dinarily be  the  case,  the  amortization  has  been  earned  from  the  begin- 
ning, but,  for  this  purpose  alone,  a  close  estimate  of  actual  value  is 
not  essential. 

The  results  presented  in  Table  8  are  made  the  basis  of  the  curves 
shown  in  Fig.  3.  Particular  attention  is  asked  to  the  lines  marked 
No.  1  and  No.  3.  The  sum  of  the  ordinates  of  the  two  No.  3  lines, 
representing  "interest"  and  "amortization,"  is  always  the  same,  and 
agrees  throughout  with  the  sum  of  the  ordinates  of  the  horizontal 
"interest"  and  "amortization"  lines  for  No.  1.  The  diagram  indicates 
plainly  the  extent  of  the  departure  of  the  other  methods  of  calculation 
from  the  correct  ones. 

Method  No.  1,  according  to  which  the  appraisal  for  rate-fixing 
purposes  is  the  investment  without  any  reduction  for  depreciation, 
has  certain  advantages  over  Methods  Nos.   3   and  4,  the  only  other 


THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES 


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843  THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES 

strictly  correct  methods  of  calculating  allowable  earnings,  whicli  may 
be  briefly  stated  as  follows: 

Method  No.  1  is  always  applicable  when  it  can  be  shown  that 
earnings  have  been  adequate  in  the  past,  no  matter  whether  the 
property  is  a  single  item,  or  is  composed  of  many  items;  whether 
the  expectancy  is  long  or  short;  whether  the  expectancy  is  uniform 
for  all  parts  of  the  property  or  not;  whether  the  plant  is  of  mature 
age  or  not;  whether  the  property  has  attained  full  growth  or  whether 
it  is  still  growing  at  a  uniform  rate,  or  otherwise.  It  is  simple  of 
application,  and  does  not  involve  determination  of  the  present  condi- 
tion of  the  property,  provided  that  it  is  maintained  in  proper  condi- 
tion to  render  adequate  service.  It  furnishes  all  the  information  neces- 
sary for  intelligent  action  in  fixing  rates,  because  when  it  is  known 
what  the  net  earnings,  above  operating  expenses,  must  be  to  yield 
the  return  which  money  should  earn  in  ordinary  safe  investments,  then 
an  arbitrary  addition  can  be  made,  to  compensate  the  owner  for 
management  and  risk  of  loss. 

In  contrast  with  these  advantages.  Method  No.  3,  under  which 
"value"  as  ordinarily  understood  must  be  determined  by  deducting 
depreciation  from  the  investment,  requires  a  special  determination  of 
value  for  each  item  of  which  the  property  is  composed,  and  a  new 
determination  every  year  for  every  item,  or  in  special  cases,  for  every 
group  of  items  of  the  same  expectancy.  Each  item  has  a  new  value 
each  year  and  a  remaining  life  which  grows  continually  shorter. 
Amortization,  therefore,  must  be  estimated  on  a  new  basis  each  year. 
The  judgment  of  the  expert  is  called  into  play  to  determine  the  condi- 
tion and  probable  remaining  life  of  the  several  parts  of  the  property, 
and  after  the  complex  calculation  is  made,  if  the  same  basic  rate  of 
interest  is  used  throughout,  the  result  should  agree  absolutely  with 
the  simpler  Method  No.  1. 

When,  for  any  reason,  the  rate  of  interest  to  be  earned  on  the 
investment  is  higher  than  the  rate  of  interest  applied  to  the  amortiza- 
tion annuity  (in  estimating  depreciation)  then,  under  Method  No.  3, 
the  net  earnings  will  follow  a  descending  scale.  The  rates  to  be 
charged,  full  compensation  being  assumed,  will  be  higher  in  the  early 
years  of  a  plant's  life  than  in  its  last  years.  This  is  an  undesirable 
feature,  resulting  from  the  application  of  Method  No.  3.  It  is  avoided 
under  Method  No.  1.     Herein  is  found  an  additional  reason  for  the 


THE  APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES  843 

general  adoption  of  the  method  of  appraisal  for  rate-fixing  purposes 
under  which  no  deduction  from  the  invested  capital  need  be  made  for 
depreciation. 

An  advantage  that  may  properly  be  claimed  for  Method  No.  3  lies 
in  this,  that  it  discloses,  more  or  less  approximately,  the  part  of  the 
capital  remaining  in  the  property,  and  therefore,  actual  value  of  its 
tangible  elements  as  such  value  would  be  estimated  by  a  purchaser. 

Method  No.  4  not  only  has  the  same  disadvantages  as  No.  3,  but 
it  is  not  acceptable,  as  has  been  explained,  owing  to  the  decrease  of 
the  earnings  with  increasing  age  of  the  plant.  Its  results  do  not,  as 
do  those  of  No.  3,  agree  from  year  to  year  with  those  of  Method  No.  1. 
J,  No.  5  is  a  method  of  approximation  which  is  applicable  whenever 
a  plant,  made  up  of  numerous  parts,  has  mature  age,  and  it  can 
be  shown  that  in  the  past  the  earnings  have  been  inadequate  to  supply 
an  amortization  fund,  in  excess  of  replacement  requirement,  which 
fund  approximates  40%  of  the  total  investment  in  perishable  prop- 
erties; and  when  no  part  of  the  invested  capital  has  been  otherwise 
returned  to  the  owner. 

When  the  practice  shall  have  been  established  of  writing  off  nothing 
from  the  investment  for  depreciation,  there  will  be  a  modification  of 
the  ordinary  system  of  keeping  accounts.  It  will  then  be  desirable 
to  open  an  "amortization  and  replacement  account,"  which  will  be 
debited  with  the  amount  of  the  amortization  actually  earned,  and  there 
will  be  credited  against  it  every  item  of  replacement.  The  discarded 
items  will  be  credited  to  the  account  of  "invested  capital"  at  their  cost, 
and  this  account  will  be  debited  with  the  cost  of  the  new  items  which 
replace  the  old. 

It  will  be  practical,  too,  to  combine  the  replacement  and  the  repair 
accounts  whenever  for  any  reason  this  may  appear  desirable.  The 
depreciated  value,  according  to  the  book  accounts,  under  such  a  system, 
can  at  any  time  be  found  by  subtracting  the  amount  in  the  amortiza- 
tion fund  from  the  invested  capital. 


.  i(..uiim 


844      DISCUSSION:  appraisal  of  public  service  properties 

DISCUSSlOlSr        -•---'"  h-tsam 

Mr.  William  Brokaw  Bamford,  M.  Am.  Soc.  C.  E.  (by  letter). — It  is 

am  ord.  axiomatic,  for  the  correct  application  of  the  principle  set  forth  by  the 
author,  or  for  the  equitable  appraisal  or  valuation  of  any  property, 
that  the  ''expectancy"  or  probable  life  of  the  property  be  determined 
within  reasonable  limits.  The  writer  is  contemplating  the  presentation 
of  a  paper  on  the  probable  life  or  endurance  of  property,  and,  for 
the  purpose  of  this  discussion,  will  point  out  only  certain  general 
principles. 

The  "expectancy"  or  "actual  life"  of  any  property  or  individual 
can  only  be  determined  by  summarizing  the  probable  "endurance" 
of  the  various  elements  which  may  affect  in  any  way  the  "actual 
life."  For  a  property,  as  for  an  individual,  the  result  at  best  is  but 
an  approximation.  Nevertheless,  it  is  possible  to  tabulate  facts  ob- 
tained over  a  series  of  years  so  that  tables  of  the  probable  life  of  a 
property  can  be  prepared  with  as  reasonable  a  degree  of  accuracy  as 
those  which  determine  the  probable  life  of  the  individual. 

Until  methods  for  properly  forecasting  the  actual  life  of  property 
are  put  on  as  stable  a  basis  as  the  preparation  of  mortality  tables  for 
human  life,  we  will  have  difficulty  in  adjusting  equitably  and 
scientifically,  the  various  financial  questions  connected  with  public 
service  as  well  as  private  property. 

For  the  purpose  of  clearness  in  discussing  the  subject,  the  writer 
has  preferred  to  devise  and  use  the  term  "endurance"  rather  than 
"actual  life,"  "expectancy,"  or  "depreciation." 

The  "endurance"  of  a  property  may  be  said  to  be  its  power  and 
ability  to  prolong  its  life  or  existence  against  the  adverse  forces  or 
influences  of  any  kind  which  threaten  it.  It  is  its  power  to  remain 
in  the  same  state  without  perishing.  The  endurance  may  be  con- 
sidered as  being  ultimately  established  by  the  "actual  life"  of  the 
property. 

It  is  indisputable  that  if  a  property  has  no  endurance  it  cannot 
last,  and  that  its  endurance  is  due  to  various  factors  which  tend  to 
prolong  or  shorten  its  life.  The  elements  which  influence  the  endur- 
ance of  a  property  might  be  divided  into  the  physical  causes  which 
threaten  its  existence  as  a  structure  (depreciation  or  deterioration) 
and  the  various  economic  or  commercial  causes  which  threaten  its  life 
as  a  property  (obsolescence).  In  addition,  there  are  certain  hazards 
which  threaten  its  life,  which  might  be  summarized  as  follows: 

(A).  Physical  Endurance  of  Property  (depreciation  or  deteriora- 
tion)— ^threatened  by: 
(i)  stability  of  structure; 


DISCUSSION  :   APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES        845 

93  -tp        (2)  physical  deterioration;  „   Mr. 

/    N    .  •   -,  •  ,         ^  Bamtord. 

\c  (a)  m  materials  composing  structure, 

o.  (&)  in  methods  of  construction. 

'^       (B).  Economic   or   Commercial   Endurance   of  Property    (obsoles- 
cence)— threatened  by: 

(1)  obsolescence    due    to    improvements    in    machinery,    pro- 

cesses, etc.; 

(2)  obsolescence  due  to  lack  of  serviceability  for  use; 

*>  (S)  obsolescence  due  to  changed  industrial  and  social  condi- 

'^  tions ; 

'^'  (J/)  actual  cost  too  excessive  for  present  value.  , 

(C).  Hazards  to  Endurance  of  Property: 
^''  (1)  destruction  by  fire; 

^''  (2)  destruction  by  act  of  God — earthquake,  cyclone,  flood,  etc. ; 

"•  •  (S)  destruction  by  domestic  violence  or  foreign  wars. 

Thus  it  will  be  seen  that  "endurance"  or  actual  life  is  threatened 
and  controlled  by  elements  composing  the  three  divisions  of  (A) 
physical  endurance,  (B)  economic  endurance,  and  (C)  hazards.  The 
actual  life,  therefore,  will  be  terminated  by  the  element  which  has 
the  least  amount  of  "endurance."  In  a  rapidly  growing  community 
and  progressive  age,  economic  endurance  is  usually  shorter  than 
physical  endurance.  In  the  present  age  evidences  of  this  are  seen  on 
every  hand,  obsolescence  terminating  the  actual  life  of  property  the 
physical  endurance  of  which  may  still  be  of  "indeterminable  duration." 

All  questions  of  depreciation,  as  usually  considered  at  the  present 
time,  should  be  resolved  into  attempts  to  establish  a  standard  for  the 
endurance  or  actual  life  of  the  property.  In  the  majority  of  engineer- 
ing investigations  of  the  endurance  of  property,  however,  the  primary 
efforts  are  directed  toward  solving  the  endurance  of  the  physical  or 
structural  elements,  to  the  neglect  or  subordination  of  the  economic  or 
commercial  elements  and  hazards. 

Neither  the  physical  nor  the  economic  endurance  can  be  considered 
alone  in  determining  the  actual  life  of  property;  both  must  be  deter- 
mined, together  with  the  hazards,  and  that  one  having  the  least 
endurance  will  be  the  one  to  govern  the  case  in  question.  The  prob- 
able physical  life  is  no  guide  to  the  probable  economic  life;  while  the 
actual  economic  life  is  a  positive  check  to  the  actual — not  the 
potential — physical  life. 

It  is  true,  of  course,  that  the  probable  economic  life  is  more 
difficult  to  determine  accurately  in  advance  than  the  probable  physical 
life;  but,  as  with  all  forms  of  insurance,  it  is  possible  to  apply  the 
law  of  averages  so  that  the  resultant  will  be  equitable  to  the  public 
service  companies  as  well  as  to  the  public. 


Oxtoby 


846      DISCUSSION :  appraisal  of  public  service  properties 

In  its  practical  application  it  would  be  advisable  to  have  a  State 
commission  to  establish  uniform  standards  for  the  determination  of 
probable  economic  life  and  "endurance,"  which  should  be  subject  to 
periodic  adjustments.  Such  a  procedure  is  not  novel,  as  the  English 
Local  Government  Board  has  undertaken  just  such  a  work  in  estab- 
lishing periods  for  the  redemption  of  authorized  bonds  for  local 
improvements.* 

Without  the  possibility  of  establishing  the  "expectancy"  or  "endur- 
ance" of  property  equitably,  the  very  admirable  methods  proposed  by 
the  author  will  prove  valueless.  It  is  hoped  that  in  the  future  more 
attention  will  be  given  to  "endurance,"  rather  than  to  concentrating 
efforts  solely  on  physical  "depreciation." 

Mr.^  James   V.    Oxtoby,   Esq.    (by   letter). — The  writer  has   read   this 

paper  with  interest,  and  wishes  to  express  his  appreciation  of  the  work 
which  Mr.  Grunsky  has  done  toward  making  clearer  the  facts  regard- 
ing the  element  of  depreciation  in  making  appraisals  of  public  utility 
properties. 

It  is  conceded  that  an  owner  of  a  public  utility  is  entitled  to 
earn  a  reasonable  return  on  his  investment.  He  must  also  receive 
from  the  business,  on  its  being  wound  up,  or  on  its  sale,  an  amount 
equal  to  the  principal  of  his  investment.  If  depreciation  of  plant  is 
provided  for  on  a  sinking-fund  basis,  the  interest  which  the  deprecia- 
tion fund  earns  is  part  and  parcel  of  that  fund,  which  must  be  added 
to  it  annually  in  order  to  bring  it  up  to  the  required  amount  at  the 
end  of  the  depreciation  period.  Otherwise,  the  fund  becomes  at  once 
impaired.  The  annual  amount  paid  into  the  sinking  fund  by  the 
business  is  smaller  than  it  otherwise  would  be,  because  it  is  expected 
that  the  earnings  of  the  fund  will  be  added  to  it,  and  that,  by  com- 
pounding the  interest  yearly,  the  fund,  at  a  predetermined  date,  will 
equal  the  amount  of  the  depreciation.  If  the  owner  uses  any  part  of 
this  fund,  whether  principal  or  interest,  he  is  really  using  part  of  the 
principal  of  his  investment. 

i-  In  appraising  a  plant  for  rate-making  purposes,  its  value  is  its 
reproduction  value,  and  not  its  reproduction  value  less  depreciation. 
The  entire  depreciation  must  be  earned  from  the  public.  If  the 
sinking-fund  method  is  used  in  computing  the  amount  of  the  yearly 
depreciation,  it  is  apparent  that  the  fund  must  exist  and  must  be  made 
to  earn  its  own  increment.  Some  students  of  this  question  have  stated 
that  the  depreciation  fund  has  already  been  earned  from  the  public, 
and  that  including  the  depreciation  fund  in  the  valuation  would  be 
requiring  the  public  to  pay  dividends  on  moneys  already  paid  in  by  it. 
This  is  not  true  where  the  sinking-fund  method  is  used.  By  that 
method  the  public  is  asked  to  pay,  not  the  full  amount  of  the  yearly 

*  Engineering  News,  Vol.  54,  p.  462. 


DISCUSSION":   APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES        847 

depreciation,  but  only  a  part  thereof,  the  compound  interest  earned     Mr. 
on  what  the  public  has  so  paid  making  up  the  deficiency. 

This  confusion  of  ideas  seems  to  result  from  the  failure  to  dis- 
tinguish between  the  repayment  and  withdrawal  of  investment  from 
year  to  year,  and  the  establishment  of  a  sinking  fund  which  does  not 
mature  until  some  date  in  the  future.  In  the  first  case  the  investor 
has  got  back  his  money  and  can  apply  it  to  other  uses.  In  the 
second  case  his  money  is  withheld  from  him,  being  locked  up  in  the 
sinking  fund;  and  he  is  not  only  unable  to  apply  it  to  other  uses,  but 
must  see  to  its  being  invested  in  absolutely  safe  securities  not  affected 
by  depreciation,  in  order  that  at  maturity  the  fund  may  be  adequate 
to  meet  the  liability  for  which  it  was  provided. 

A  similar  confusion  of  ideas  affects  many  students  when  they  are 
called  on  to  state  a  fair  price  for  a  utility  expropriated  as  a  going 
concern.  They  err  in  stating  the  price  as  reproduction  less  deprecia- 
tion, the  vendor  to  retain  the  depreciation  fund.  In  practice  the 
depreciation  fund  is  locked  in  securities  which  may  or  may  not  be 
then  marketable  for  their  assumed  value.  The  law  authorizing  ex- 
propriation should  impose  on  the  purchaser  the  burden  of  marketing 
these  securities  promptly,  or  of  purchasing  them  himself.  Otherwise, 
the  investment  made  by  the  vendor  is  not  fully  released.  In  this 
the  writer  intentionally  omits  reference  to  the  equitable  requirement 
of  a  higher  price  in  expropriation  proceedings  than  in  rate-making 
proceedings. 

Assume  an  investment  of  $25  000  made  in  a  plant,  which,  at  the 
end  of  twenty  years,  will  have  a  depreciated  or  junk  value  of  $5  000. 
Assume  6%  as  fair  return  on  the  plant  investment  and,  for  con- 
venient figuring,  assume  that  it  is  possible  to  invest  a  sinking  fund 
in  safe  securities  paying  6  per  cent.  Table  12  is  based  on  these 
assumptions,  and  on  the  further  assumption  that  the  sinking-fund 
method  of  calculating  depreciation  is  correct. 

From  the  foregoing  it  is  evident  that  if  the  owner  is  required  to 
accept  as  profit  less  than  $1  500  yearly,  he  has  been  deprived  of  a 
reasonable  return  on  his  $25  000  investment. 

A  plant  probably  could  not  continue  to  operate  usefully  without 
replacement  before  the  end  of  the  depreciation  period,  but  this  illustra- 
tion, taken  with  the  many  which  Mr.  Grunsky  has  furnished,  demon- 
strates the  principle  that  if  the  annual  depreciation  is  computed  on  a 
sinking-fund  basis,  it  is  inequitable  to  use  depreciated  value  alone  as 
the  basis  for  the  reasonable  return  to  which  the  owner  is  entitled. 

If   the   depreciation   is   computed    on   the   straight-line   basis,   the 
interest  which  the  depreciation  fund  earns  is  really  an  earning.     If 
depreciation  thus  computed  is  paid  to  and  withdrawn  by  the  owner,  ' 
he  is  entitled  to  earn  his  fair  return  only  on  the  remaining  value. 


848      discussion:  appraisal  of  public  service  properties 


Mr.       The  owner  of  a  public  utility,  however,  is  bound  to  keep  up  the  plant 
^^  ^'  to  a  high  degree  of  efficiency  and  must  rehabilitate  it  when  necessary, 
which  practically  precludes  withdrawal. 


TABLE  12. 


^ 


Mr. 
Higgins, 


Year. 

Value  of 
plant  at  end  of 

Return  of  6% 

Annual 
depreciation 

Interest  on 

Total    -fl 
depreciation 

year,  by 

$25  000. 

sinking  fund, 

fund  at  6%. 

fund  at 

assumption. 

6%  basis. 

end  of  year. , 

0 

$25  000.00 
24  456.31 

" 

!? 

1 

$1  500.00 

$543.69 

$543.69     n 

2 

23  880.00 

1  500.00 

543.69 

$32.68 

1  120.00      i 
1  730.89    •« 

8 

23  269.11 

1  500.00 

543.69 

67.20 

4 

22  621.58 

1  500.00 

543.69 

103.85 

2  378.42     >t 

5 

21  935.22 

1  500.00 

543.69- 

142.70 

3  064.78 

6 

21  207.60 

1  500.00 

543.69 

183.88 

3  792.40 

7 

20  436.37 

1  500.00 

543.69 

227.54 

4  563.63 

8 

19  618.82 

1  500.00 

543.69 

273.81 

5  881.12 

9 

18  752.46 

1  500.00 

543.69 

322.86 

6  247.54 

10 

17  834.16 

1  500.00 

543.69 

874.85 

7  165.84 

11 

16  860.52 

1  500.00 

543.69 

429.95 

8  139.48 

12 

15  828.46 

1  500.00 

543.69 

488.87 

9  171.54 

18 

14  734.48 

1  500.00 

543.69 

550.29 

10  265.52 

14 

13  574.86 

1  500.00 

543.69 

615.93 

11  425.14 

15 

12  345.07 

1  500.00 

543.69 

685.5(1 

12  654.93 

lb 

11  042.09 

1  500.00 

543.69 

759. '-J9 

18  957.91 

17 

9  660.93 

1  5(K).00 

543.69 

837.47 

15  339.07 

18 

8  196.90 

1  500.00 

513.69 

920.34 

16  808.10 

19 

6  645.02 

1  500.00 

543.611 

1  008.19 

18  854.98 

20 

5  000.00 

1  500.00 

543.69 

1  101.83 

20  000.00 

Mr.  Grunsky  demonstrates  that  if  the  depreciation  fund  is  used 
for  replacements,  which  themselves  at  once  commence  to  depreciate, 
the  sinking-fund  method  is  impracticable.  The  fact  is  that  deprecia- 
tion is  not  an  exact  quantity,  but  must  be  determined  by  the  exercise 
of  fair  judgment.  Its  amount  at  any  time  is  the  difference  between 
actual  investment  and  present  value.  It  is  highly  improbable  that, 
during  a  series  of  years,  the  actual  depreciation  of  a  plant  will 
coincide  with  the  accumulation  of  money  by  a  sinking-fund  rule. 
A  public  service  plant  should  be  maintained  from  its  earnings  so  that 
its  present  value  will  always  equal  its  original  cost.  If  not,  the 
difference  should  be  in  a  depreciation  fund,  by  whatever  method  it  is 
computed;  and  a  fair  return  should  be  computed  on  the  total  value 
which  serves  the  public,  whether  this  value  is  in  plant  or  in  deprecia- 
tion reserve.  Real  earnings  by  the  depreciation  reserve  are  a  part  of 
the  earnings  of  the  plant.  The  increment,  however,  of  a  fund  which 
is  accumulating  on  a  sinking-fund  basis  is  not  an  earning. 

In  this  discussion  the  writer  has,  in  general,  merely  stated  in  his 
own  way  ideas  which  appear  in  the  paper.  His  appreciation  of  the 
argument  contained  therein  has  been  his  excuse  for  doing  so. 

Charles  H.  Higgins.  M.  Am.  See.  C.  E. — This  paper  should  receive 
the  careful  attention  of  the  members  of  this  Society,  for  it  deals  with 
matters  far  more  fundamental  than  a  reading  of  the  title  or  introduc- 


DISCUSSION  :   APPRAISAL  OF  PUBLIC   SERVICE  PROPERTIES        849 

tion  might  lead  one  to  believe.  In  fact,  nowhere  has  the  speaker  ^  Mr^^ 
found  the  main  issue  stated  clearly,  but  a  student  of  these  matters 
cannot  read  this  paper  carefully  without  finding  the  author  constantly 
returning  to  this  undefined  issue.  Whether  it  be  veiled  purposely  or 
merely  clouded  because  not  clearly  seen  by  the  author,  it  cannot 
escape  being  the  point  of  such  overwhelming  importance  in  this 
paper  as  to  challenge  attention. 

On  page  773  occurs  the  following  sentence: 

"Perhaps  the  use  of  the  term,  'value,'  in  this  connection  is  un- 
fortunate, because  it  is  not  clear  why  'value,'  as  ordinarily  defined 
(which  is  not  always  synonymous  with  capital  reasonably  and  properly 
invested),  should  be  made  the  criterion  of  allowable  earnings." 

^^^  And,  again,  on  page  820: 

"*  *  *,  and  to  the  ruling  of  the  Courts,  which  hold  that  owners 
of  public  service  properties  are  entitled  to  a  fair  return  on  the  'value' 
of  such  properties. 

"If  it  be  found  that  the  ruling  of  the  Courts  is  not  subject  to 
modification,  or,  in  other  words,  that  appraisals  must  be  'value,'  as 
'value'  would  be  determined  by  a  purchaser,  that  is  to  say,  for  the 
tangible  elements  in  most  cases,  cost  or  cost  of  replacement  less 
depreciation,  or  something  practicallv  equivalent  thereto,     *     *     *." 

In  these  lines  the  real  meat  of  the  matter  may  be  found,  the 
author  taking  issue  with  the  decisions  of  the  United  States  Supreme 
Court. 

Stripped  of  all  verbiage,  this  paper  deals  then,  not  with  the  methods 
of  making  appraisals  of  public  service  properties  under  the  existing 
law  as  interpreted  by  the  Supreme  Court,  but  with  what,  in  Mr. 
Grunsky's  opinion,  the  law  should  be.  The  latter  may  well  be  an 
equally  proper  matter  for  discussion  before  this  Society,  but  it  is 
certainly  very  different  from  the  former. 

To  present  this  matter  clearly,  the  speaker  will  illustrate.  As 
early  as  1898,  in  the  leading  case  of  Smyth  v.  Ames,*  in  the  Nebraska 
maximum  rates  cases,  the  Supreme  Court  laid  down  the  principle 
that  the  basis  of  all  calculations,  as  to  the  reasonableness  of  rates, 
must  be  the  fair  value  of  the  property  used,  and  specified  certain 
matters  to  be  taken  into  consideration  in  ascertaining  the  fair  value: 
the  original  cost  of  construction,  the  amount  expended  in  permanent 
improvements,  the  amount  of  market  value  of  the  bonds  and  stock, 
the  present,  as  compared  with  the  original,  cost  of  construction,  the 
probable  earning  capacity  of  the  property  under  the  particular  rates 
prescribed,  and  the  sum  required  to  meet  operating  expenses;  all  to  be 
given  such  weight  as  would  be  just  and  right  in  each  case.  Justice 
Harlan  was  careful  to  add :  "We  do  not  say  that  there  may  not  be  other 
matters  to  be  regarded  in  estimating  the  value  of  the  property." 

*  169  U.  S.,  466. 


850      DISCUSSION :  appraisal  of  public  service  properties 

Mr.  The  following  year,  in  the  case  of  the  San  Diego  Land  Company 

igsins..  ^^  IS'ational  City,*  the  Court  held  "what  the  Company  is  entitled  to 
demand  in  order  that  it  may  have  just  compensation  is  a  fair  return 
upon  the  reasonable  value  of  the  property  at  the  time  it  is  being  used 
for  the  public."  The  Supreme  Court,  then,  as  early  as  1899,  had 
adopted  present  value  as  the  standard,  leaving  undetermined  how  a 
reasonable  value  is  to  be  ascertained  and  what  constituted  a  fair 
return. 

Again,  in  1903,  in  San  Diego  Land  and  Town  Company  v.  Jasper,t 
the  Court  said: 

"It  no  longer  is  open  to  dispute  under  the  Constitution  that  what 
the  Company  is  entitled  to  demand,  in  order  that  it  may  have  just 
compensation,  is  a  fair  return  upon  the  reasonable  value  of  the 
property  at  the  time  it  is  being  used  for  the  public." 

In  a  masterly  review  of  the  subject  of  regulation  of  railway  rates, 
Judge  Swayze,  of  the  Supreme  Court  of  New  Jersey,  says : 

"Novel  questions  of  this  character  will  arise  with  increasing  fre- 
quency, and  require  the  most  careful  consideration.  Like  most  other 
questions  in  every  department  of  law,  they  are  in  their  origin  rather 
questions  of  fact  than  questions  of  law,  although  in  course  of  time 
the  rules  become  settled  and  thus  become  rules  of  law.  In  their 
origin  and  as  yet  many  are  questions  of  sound  business  management 
and  engineering  science.  The  law  prescribes  reasonable  return  upon 
a  reasonable  valuation.  What  is  a  reasonable  return  and  what  is  a 
reasonable  valuation  must  vary  with  the  circumstances  of  each 
particular  case.":): 

It  may  be  accepted  then  as  an  established  rule  that  the  appraisal 
of  a  public  service  property  to  be  used  in  fixing  rates  should  show  the 
fair  value  of  the  property. 

Now,  Mr.  Grunsky  argues  that  for  the  fair  "value"  of  the  Supreme 
Court  there  should  be  substituted  something  which  he  calls  "capital 
properly  and  reasonably  invested,"  stating,  as  a  fundamental  principle, 
that: 

"The  valuation  of  a  public  service  property  and  its  earnings  must 
bear  such  relation  to  each  other  that  there  will  be  returned  to  the 
owner,  within  the  life  of  the  property,  the  capital  which  he  has  prop- 
erly invested  in  it,  and  in  addition  thereto,  interest  at  a  reasonable 
rate,  upon  such  amount  of  capital  as  from  time  to  time  actually  and 
properly  remains  in  the  property  as  an  investment." 

In  this  Mr.  Grunsky  takes  issue  with  the  Fourteenth  Amendment 
as  interpreted  by  the  Supreme  Court  since  1898. 

The  author's  "fundamental  principle"  quoted  above,  if  applied,  as 

*  174  U.  S.,  739. 
+  189  U.  S.,  439. 
t  Quarterly  Journal  of  Ecovotnics,  May,  1912. 


DISCUSSION  :   APPRAISAL  OF  PUBLIC   SERVICE  PROPERTIES        851 

outlined  in  the  paper,  would  cut  both  ways.  In  determining  what  is  Mr. 
termed  "capital  reasonably  and  properly  invested"  according  to  the  '^^"'®- 
author's  plan,  earnings  and  dividends,  or  interest,  are  considered 
apparently  from  the  beginning,  and,  if  these  dividends  have  been  less 
than  what  is  determined  as  a  reasonable  rate  of  return,  the  difference 
is  considered  as  remaining  in  the  property  as  invested  capital.  On 
the  other  hand,  in  the  case  of  past  earnings  above  the  determined 
rate,  Mr.  Grunsky  speaks  as  follows:  "It  is  possible,  of  course,  in  the 
case  of  large  earnings  in  the  past,  that  a  portion  thereof  should  be 
considered  as  capital  returned  to  the  owner."  In  other  words,  the 
author  would  appear  to  propose,  not  only  the  determining  by  a  State 
of  a  reasonable  rate  for  the  present  and  future,  but  actually  to  make 
it  retroactive. 

Mr.  Grunsky  seems  inclined  to  treat  all  investors  as  if  they  were 
owners  of  State  bonds.  For  a  lucid  explanation  of  the  relative  posi- 
tions of  the  holders  of  different  classes  of  securities  and  their  relation 
to  the  public,  nothing  better  in  its  way  can  be  found  than  the  Report 
of  the  Railroad  Securities  Commission,  of  which  President  Hadley,  of 
Yale  University,  was  Chairman. 

To  the  speaker's  mind,  the  Courts,  in  fixing  on  fair  valuation  as 
the  basis  for  all  calculations,  have  taken  the  only  position  economically 
sound. 

The  speaker  accepts  the  conclusion  of  Judge  Swayze  already 
quoted:  "The  law  prescribes  reasonable  return  upon  a  reasonable 
valuation.  What  is  a  reasonable  return  and  what  is  a  reasonable 
valuation  must  vary  with  the  circumstances  of  each  particular  case." 
This  states  clearly  the  proposition  before  an  engineer  making  an 
appraisal  or  valuation  for  use  in  the  fixing  of  rates  under  the  law  as 
it  exists  to-day,  and  there  are  enough  technical  difficulties  yet  to  be 
settled  by  engineers.  The  broader  question  dealt  with  in  this  paper 
is  very  interesting,  but  should  not  be  confused  with  methods  under 
the  law  as  established. 

Henry  Floy,  M.  Am.  Soc.  C.  E. — The  speaker  cannot  agree  with  Mr. 
the  views  expressed  by  Mr.  Higgins.  Mr.  Grunsky  has  brought  out  ^^^^' 
quite  clearly  a  very  important  question,  which  must  still  be  fought  out 
and  decided  by  the  Supreme  Court,  and  that  is,  the  basis  of  "fair  value." 
The  various  opinions  rendered  by  the  Supreme  Court  have  not  yet 
fairly  and  squarely  determined  the  question  as  to  whether  or  not  "fair 
value"  shall  be  taken  as  that  derived  from  a  consideration  of  accruing, 
theoretical  depreciation,  or  something  in  addition  to  such  value.  The 
speaker  is  inclined  to  agree  with  the  author  that  the  investor  is  en- 
titled to  a  return  on  his  investment,  or  the  cost  of  reproduction,  if  his 
property  is  kept  in  good  operating  condition.    Present  value  accurately 


852      discussion:  appraisal  of  public  service  properties 

Mr.   obtained  from  a  consideration  of  accruing  depreciation  must  vary  from 

°^'  day  to  day,  thus  forming  a  fluctuating  and  impractical  value  on  which 

to  base  rates  or  capitalization.     Such  fluctuating  value  is  too  unstable 

and  unfair  ultimately  to  be  received  and  accepted  for  fair  value,  as  the 

author  has  brought  out. 

J!  It  is  very  difficult,  even  for  lawyers,  to  interpret  the  decisions  of 
the  Court,  and  surely  it  is  much  more  difficult  for  engineers  to  ascer- 
tain exactly  what  these  decisions  of  the  Supreme  Court  which  have 
been  referred  to — the  Consolidated  Gas  case  and  the  Knoxville  Water 
case — mean  in  the  last  analysis.  It  would  seem  as  if,  by  these  decisions, 
the  Court  intended  to  convey  the  idea  that  something  more  than  a 
theoretically  depreciated  value  should  be  made  the  basis  on  which  a 
return  is  to  be  allowed. 

It  is  possible  that,  if  "the  recall"  is  established,  some  new  decisions 
may  be  expected;  yet,  at  the  present  time,  we  may  feel  confident  that 
the  Courts,  regardless  of  how  excessive  the  returns  have  been  in  the 
past,  would  maintain  the  position  that  present  and  future  returns  will 
be  based  on  the  fair  value  of  the  property.  The  Courts  will  not  attempt 
to  reduce  earnings  in  the  present  below  the  fair  return  on  the  fair 
value  of  the  property,  even  though  the  owner  for  some  years  previously 
has  been  earning  more  than  a  fair  return. 

A  return  of  4%  has  been  mentioned  in  the  discussion,  but  the 
Supreme  Court  has  never  yet  named  anything  less  than  6%,  and  that 
for  conditions  such  as  exist  for  a  monopoly  in  New  York  City.  Of 
course,  a  fair  return  for  any  particular  property  depends  on  that 
property,  and  one  like  the  Consolidated  Gas  Company  in  New  York 
City — a  monopoly  in  the  greatest  city  in  America — is  not  running  as 
much  risk  in  the  way  of  securing  a  return  as  some  other  property  in  a 
small  town  in  the  West,  and  the  Courts  and  Commissions  have  recog- 
nized this  fact.  The  Commission  of  New  York  City,  for  example,  has 
in  certain  decisions  explicitly  stated  that  certain  gas  and  electric 
corporations  were  entitled  to  a  return  of  7i  or  8%  on  the  total  value 
of  their  properties.  This  means  that  the  stockholder  may  obtain  a.  very 
much  higher  rate  of  interest  for  his  holdings,  while  the  bondholders, 
who  have  a  prior  lien  on  the  property,  are  willing  to  accept  a  4,  5,  or 
6%  return  for  their  share  of  the  investment. 

In  the  matter  of  valuing  real  estate,  the  Courts  have  quite  generally 
held  that,  in  determining  present  value,  the  owner  is  entitled  to 
appreciation,  and  this  theory  was  distinctly  enunciated  in  the  Consoli- 
dated Gas  case,  where  the  U.  S.  Circuit  Court  approvingly  quotes  the 
language  of  the  Supreme  Court  in  another  case  to  the  effect  that  "the 
value  of  the  property  at  the  time  it  is  being  used"  should  be  taken. 

It  must  be  recognized  that  fair  values  may  be  different  for  different 


discussion:  appraisal  of  public  service  properties      853 

purposes.  The  property  of  a  corporation  which  is  to  be  assessed  for  Mr.  -r 
the  purpose  of  special  franchise  tax  in  New  York  City,  for  example,  °^' 
would  have  a  different  value  from  that  computed  for  other  purposes, 
because  a  franchise  tax  relates  only  to  the  property  in  the  street,  which 
may  be  a  relatively  small  part  of  the  total  property  of  the  corporation. 
The  value  of  property  for  rate-making  purposes,  in  a  similar  way,  may 
not  be  the  same  as  that  for  capitalization,  because  a  part  of  the 
property  may  be  held  simply  as  an  investment  or  in  connection  with 
an  allied  business,  so  that  the  value  for  rate-fixing  purposes,  in  such 
case,  would  be  quite  different  from  the  value  proper  for  capitalization. 
These  questions  of  "fair  value"  are  of  comparatively  recent  origin, 
and  are  by  no  means  easy  of  solution.  Until  a  few  years  ago,  no  one 
appreciated  or  considered  the  fact  that  the  operation  of  public  utility 
property  was  a  matter  of  much  public  concern.  Public  utilities  were 
given  grants  and  encouraged  to  make  investments  with  the  expectation 
of  large  returns,  certainly  8  or  10%,  possibly  15  or  20%;  but  lately, 
as  the  corporations  have  developed  and  become  in  many  instances 
monopolies,  either  through  crushing  out  competition  or  buying  up 
their  competitors,  the  public  has  been  compelled  to  deal  with  the 
situation  on  a  basis  radically  different  from  that  formerly  allowed. 
This  has  resulted  in  the  development  of  what  may  be  called  a  theory, 
which  we  are  attempting  to  make  a  science,  with  regard  to  the  control 
and  operation  of  public  utility  properties,  so  that  the  situation  is  quite 
different  from  anything  that  existed  fifteen  or  twenty  years  ago. 
To-day  we  look  upon  a  public  utility  corporation  as  entitled  to  special 
privileges,  such  as  the  use  of  public  streets,  the  right  of  condemnation, 
permission  to  exist  perhaps  as  a  monopoly,  in  return  for  which,  in  view 
of  some  assurance  of  reasonable  profit,  we  limit  the  return  on  the  value 
of  the  property  to  a  fair  amount,  which,  while  greater  than  that 
received  from  a  Government  bond  or  municipal  security,  is  neverthe- 
less smaller  than  would  be  judged  reasonable  for  an  industrial  concern, 
where  the  risks  are  greater.  In  brief,  the  peculiar  conditions  surround- 
ing any  specific  corporation  must  be  considered  both  in  fixing  the  fair 
value  of  the  property  and  fair  return  thereon. 

J.  Martin  Schreiber^  M.  Am.  Soc.  C.  E. — The  author  has  presented       Mr. 
a  remarkable   analysis,   and  has   approached   the   subject  in   a   liberal    ^  ^^^  ®'" 
manner,  which  is  certainly  required  for  a  rate  investigation,  if  a  sound 
conclusion  is  to  be  expected. 

The  greatest  difficulty  is  in  the  practical  application  of  the  prin- 
ciples which  have  been  set  forth.  In  discussing  the  paper  by  Mr. 
Riggs,*  the  speaker  brought  up  the  question  of  fair  values  in  relation 
to  present  physical  values.  Also,  in  a  recent  investigation  of  the  de- 
preciation of  certain  elements  of  physical  property,  he  interviewed 
*  Transactions,  Am.  Soc.  C.  E.,  Vol.  LXXII,  p.  1. 


854      discussion:  appraisal  of  public  service  properties 

Mr.  leading  specialists  eminently  fitted  to  give  the  information  desired. 
^'  Some  of  these  men  replied  that  they  would  not  even  attempt  to  desig- 
nate the  correct  life,  if  changes  in  the  art  were  to  he  considered;  and, 
of  course,  an  estimate  of  the  life  of  property  without  the  consideration 
of  obsolescence  would  be  valueless.  To  take  a  practical  case:  It  is 
reported*  that,  in  the  recent  valuation  of  the  Elevated  Railroads  of 
Chicago,  the  value,  exclusive  of  roadway  and  overhead  charges,  sub- 
mitted by  the  Chicago  Harbor  and  Subway  Commission,  was 
$26  354  217 ;  the  appraisement  by  the  A.  L.  Dunn  Company  was 
$40  750  892,  and  the  valuation  by  George  F.  Swain,  M.  Am.  Soc.  C.  E., 
was  $34  634  396.  Now,  it  does  not  appear  to  be  fair  to  the  stockholders 
to  be  asked  to  abide  by  any  method  showing  such  variations.  It  should 
be  admitted  that  a  fair  valuation,  representing  moneys  properly  invested 
for  property  which  has  been  built  up  by  the  piecemeal  method,  with 
equipment  constantly  changing  on  account  of  the  development  of  the 
art,  along  with  unreliable  book  records,  with  their  varying  accounting 
methods,  is  a  very  difficult  proposition.  This  is  especially  true  when 
one  must  take  into  consideration  the  vague  item  of  overhead  charges; 
thus  far,  that  item  has  generally  been  determined  by  setting  apart  an 
arbitrary  percentage.  For  this  reason  the  speaker  is  of  the  opinion  that 
a  valuation,  particularly  of  old  properties,  for  rate  purposes  based  on 
earning  power,  is  more  reliable  than  the  method  which  takes  the  values 
of  actual  physical  properties  as  the  governing  data.  Also,  the  value  for 
rate  making  should  not,  necessarily,  be  ascertained  by  the  same  plan 
as  the  value  for  taxes  or  bonds. 

Assuming  that  a  fair  valuation  is  known,  another  very  pertinent 
practical  question  is :  "What  is  to  be  allowed  to  the  stockholder  ?"  The 
speaker  believes  that  the  general  tendency  is  to  place  too  low  a  limit 
on  proper  earnings.  One  should  not  expect  to  raise  money  to  finance 
projects  which  carry  with  them  a  large  element  of  risk  at  savings 
account  dividends,  even  if  the  utility  appears  to  be  reasonably  safe. 
The  investor  knows  full  well  that  there  are  still  such  contingencies 
as  strikes,  earthquakes,  floods,  and  lean  years,  and  that  it  is  absolutely 
impossible  to  anticipate  these  conditions;  besides,  if  one  expects  the 
country  to  develop,  one  must  also  encourage  the  honest  man  with  the 
•"'''       brains  and  energy. 

.19'   !■ 

Mr.  William  J.  Boucher,  Assoc.  M.  Am.  Soc.  C.  E. — During  a  part 

one  er.  ^^  iQii^  the  speaker  had  certain  work  in  connection  with  an  appraisal 

of  the  lines  of  the  Illinois  Central  Railroad  in  Illinois.     The  values 

given  to  the  right  of  way  in  Chicago,  from  Randolph  to  12th  Streets, 

presented  some  interesting  phases. 

When  the  road  was  constructed,  about  1853,  this  section  was  built 
on  piles  and  over  the  waters  of  Lake  Michigan,  to  a  terminal  at  Ran- 
dolph Street.     This  space  has  since  been  filled  in;  the  width  of  the 

*Electric  Railway  Journal,  May  18th,  1912,  p.  829. 


DISCUSSION  :   APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES        855 

right  of  way  varies  from  100  to  400  ft.,  is  depressed  some  12  ft.  below  Mr. 
the  general  level,  and  is  contained  between  retaining  walls,  beyond 
which,  on  the  east  and  west  sides,  lies  Grant  Park.  The  railroad  oc- 
cupies a  most  unique  and  valuable  grant  for  about  Y  miles  south  from 
Randolph  Street,  lying,  as  it  does,  along  the  shore  of  the  Lake,  giving 
space  for  eight  running  tracks,  a  roundhouse  and  car-cleaning  and 
storage  yards.  It  is  a  popular  notion,  which  the  speaker  cannot  verify, 
that  the  land  cost  the  railroad  company  nothing,  but  was  granted  as  K 

an  inducement  to  enter  the  city. 

The  westerly  edge  of  the  right  of  way  through  Grant  Park  is  500 
ft.  or  more  from  the  property  line  of  Michigan  Avenue,  the  nearest 
property  which  is  ever  for  sale  and  has  a  definite,  taxable  value.  The 
Company,  in  its  appraisal,  placed  a  square-foot  value  (seemingly  very 
high)  on  all  the  right  of  way,  in  addition  to  improvement  values,  such 
as  filling,  which  the  Company  had  done,  beginning  at  Randolph  Street 
and  increasing  toward  the  south  until  it  reached  a  maximum  opposite 
Jackson  Boulevard,  where  property  values  along  Michigan  Avenue  are 
the  highest,  and  then  decreasing  again  until  12th  Street  was  reached. 

The  question  then  arises :  How  were  the  values  arrived  at  for  prop- 
erty which  had  probably  never  cost  the  railroad  company  anything, 
which  is  located  500  ft.  from  the  nearest  property  for  a  comparison 
of  values,  and  which  to-day  could  not  be  acquired  for  railroad  purposes 
in  any  manner  or  under  any  circumstances?  And,  further,  is  a  rail- 
road company  justified  in  placing  a  value  in  excess  of  $36  000  000  on 
such  a  property  for  appraisal  purposes? 

Another  matter  regarding  railroad  finances  has  often  interested  the 
speaker:  One  frequently  sees,  in  the  daily  press,  announcements  of  the 
sale  of  bonds  of  various  railroads,  which  read  somewhat  as  follows : 

"The  A.  B.  &  C.  R.  R.  is  offering  for  sale  $1  000  000  of  4%  bonds, 
secured  by  various  underlying  securities  (mentioned).  Of  this  amount, 
$500  000  is  to  be  applied  to  renewals  of  bridges  and  rails  and  $500  000 
for  new  cars  and  new  locomotives." 

The  question  that  arises  is  this:  Is  such  use  of  a  bond  sale  proper, 
if  depreciation  on  rails,  bridges,  cars,  and  locomotives  has  been  charged 
off?  Why  not  use  the  funds  from  such  depreciation  account?  Why 
is  it  proper  or  necessary  to  issue  bonds  for  these  ordinary  renewals, 
which  in  the  usual  course  of  events  must  be  taken  care  of,  and  must 
be  expected?  It  has  always  seemed  to  the  speaker  to  be  improper. 
Where  is  it  going  to  lead  the  corporation,  and  where  will  it  end,  to 
keep  adding  to  the  capital  account  and  paying  interest  on  worn-out 
and  scrapped  material? 

R.  D.  Coombs,  M.  Am.  Soc.  C.  E. — In  a  hypothetical  case,  such  as     Mr. 
a  corporation  having  paid  for  a  number  of  years  a  very  high  dividend    °°™  ^' 


Coombs. 


856      DISCUSSION:  appraisal  of  public  service  properties 

Mr.      rate,  should  those  dividends  be  deducted  from  the  capital  before  fixing 
the  amount  on  which  they  could  properly  be  paid? 

To  consider  an  exaggerated  case,  suppose  some  corporation  had  been 
paying  about  50%  dividends  for  four  or  five  years;  if  the  Court 
decides  that  the  corporation  can  charge  only  such  a  rate  as  will  enable 
it  to  pay  a  fair  percentage  on  present  value,  must  those  50%  dividends 
for  four  or  five  years  be  deducted? 

A.  H.  Van  Cleve,  M.  Am.  Soc.  C.  E. — Mr.  Grunsky  has  undoubt- 
edly rendered  a  great  service  to  the  Engineering  Profession  in  setting 
forth  so  clearly  the  methods  to  be  used  in  the  appraisal  of  public  service 
property  for  rate-making  purposes.  While  there  are  marked  differences 
of  opinion  as  to  the  methods  which  should  be  used  in  such  cases,  the 
author's  examples  and  tabulations  illustrate  so  completely  the  princi- 
ples which  he  advocates  that  his  results  and  the  methods  of  reasoning 
which  lead  up  to  them  are  entirely  clear.  His  statement  of  funda- 
mental principles  is  especially  valuable,  but  the  speaker  begs  to  differ 
with  him  in  respect  to  Principle  No.  18  as  applied  in  a  water-power 
development  the  output  of  which  is  used  for  supplying  electrical  cur- 
rent to  the  public.     That  principle  is  stated  as  follows : 

"Intangible  values  should  be  disregarded,  in  making  appraisals  for 
rate-fixing  purposes,  excepting  only  when  the  rate  of  net  return  is 
deliberately  fixed  at  or  too  near  the  rate  earned  by  ordinary  safe  invest- 
ments, in  which  case  an  arbitrary  addition  to  the  appraisal,  under 
whatever  name,  should  be  made.  The  interest  on  this  item  of  the 
appraisal  will  be  the  reward  of  the  owner  for  management  and  for  any 
hazard  which  the  business  may  involve." 

In  the  case  of  a  water-power  development,  the  value  of  the  water 
right,  which  is  an  intangible  value,  is  one  of  the  most  important  items 
to  be  considered  in  determining  the  value  of  the  plant,  not  only  for 
purposes  of  sale,  but  for  the  determination  of  the  rates  which  may 
be  properly  charged  by  the  owners  of  that  plant  for  the  service  which 
they  render;  and  the  consideration  of  this  item  is  essential,  regardless 
of  the  question  of  the  rate  earned  by  ordinary  safe  investments.  To 
neglect  the  value  of  a  water  right  would  work  a  grave  injustice  to  its 
owner,  for,  in  many  cases,  if  only  the  tangible  values  of  the  several 
parts  of  the  plant  are  considered  by  the  rate-making  body,  and  the 
returns  to  the  owner  are  estimated  at  an  ordinary  rate  of  interest 
thereon,  together  with  due  allowance  for  amortization  and  all  other 
items  which  may  properly  be  included,  it  would  result  in  compelling 
him  to  furnish  service  to  the  public  at  a  rate  far  below  that  for  which 
the  same  service  could  be  furnished  by  a  plant  producing  the  same 
power  from  any  source  other  than  water. 

It  is  true  that  the  author,  in  Principle  No.  17,  states:  "Proper 
investments  for  franchises,  for  water  rights,  and  the  like,  are  always 
to  be  included  in  the  appraisal."  It  is  frequently  the  case,  however, 
that,  although  no  investment  has  been  made  directly  for  the  acquisition 


discussion:  appeaisal  of  public  service  properties      857 

of  the  water  right,  the  value,  nevertheless,  exists,  and  should  always  be       Mr. 
considered   in    a   valuation.      The   correctness    of   this   principle   may    ^° 
perhaps  be  most  clearly  demonstrated  by  an  example: 

Let  it  be  assumed  that  A  is  the  owner  in  fee  simple  of  lands  lying 
between  two  streams,  the  water  in  one  of  which  is  at  a  material  eleva- 
tion above  that  in  the  other;  that  this  property  has  been  in  his 
possession  for  many  years,  and  that  the  price  paid  for  the  land  was 
the  fair  and  reasonable  value  of  it  for  farm  purposes;  that  A  as  a 
riparian  ovsmer  has  the  right  to  withdraw  water  from  the  upper 
stream  and  discharge  it  into  the  lower  stream;  and  that  he  has 
complied  fully  with  all  the  legal  requirements  necessary  for  this  pur- 
pose. A  is  then  the  possessor  of  a  water  right  for  which  no  expenditure 
has  been  made  by  him.  Let  it  be  assumed,  further,  that  in  a  city 
located  within  reasonable  transmission  distance  there  is  a  market  for 
the  electrical  current  which  can  be  produced  by  the  water  which  may 
be  withdrawn  from  the  upper  stream  adjoining  A's  property  and  dis- 
charged into  the  lower  stream,  and  that  A  determines  to  grasp  the 
opportunity  to  make  use  of  a  water  right  which,  before  the  advances 
in  the  art  of  transmission,  was  practically  valueless,  owing  to  the  lack 
of  any  market  in  the  immediate  vicinity  of  his  property.  Having 
obtained  the  necessary  franchise  in  that  city,  in  due  course  he  enters 
into  contract  for  the  sale  of  this  power  to  the  municipality  and  to  the 
citizens  thereof,  and  the  plant  which  he  has  built,  therefore,  becomes  a 
public  service  property.  In  the  course  of  time  a  rate-making  body  is 
called  on  to  decide  as  to  the  fair  and  just  returns  which  he  shall 
receive  on  his  investment,  and  the  value  of  the  water  right  becomes — 
as  it  will  be  shown — by  far  the  most  important  factor  in  determining 
those  rates.  In  order  to  simplify  the  illustration,  let  it  be  assumed 
that  the  just  returns  are  to  be  determined  for  power  at  the  city  limits 
after  the  voltage  has  been  reduced  for  safe  distribution,  and  thus 
eliminate  from  consideration  the  cost  of  the  distributing  plant. 

It  is  found  that  the  plant  is  capable  of  developing  at  all  times 
25  000  e.h.p.  at  the  switch-board,  and  that  the  original  cost  and  also 
the  replacement  value  of  the  tangible  values  included  in  the  plant  are 
equivalent  to  $40  per  e.h.p.,  that  the  corresponding  tangible  value  of 
the  transmission  line  is  $6  per  e.h.p.,  and  that  of  the  step-up  and  step- 
down  transformer  station  and  switch-board  apparatus  represents  an 
investment  of  $14  per  e.h.p.,  or  a  total  of  $60  per  e.h.p.  of  actual  invest- 
ment in  tangible  property.  The  load  factor  is  found  to  be  50%,  and 
13%  the  average  loss  in  transmission  and  transformation.  The  power 
available  for  sale  at  the  city  limits,  therefore,  is  21  750  e.h.p.,  and  the 
average  power  sold  throughout  the  year  is  10  875  e.h.p.,  or  43.5%  of  the 
total  installed  capacity. 

Assuming  the  average  life  of  the  plant  to  be  20  years,  and  that 
5%  is  a  fair  and  reasonable  return  on  the  investment,  the  annual 
fixed  charges  and  operating  expenses  per  electric  horse-power  would 


858      DISCUSSION:  appraisal  of  public  service  properties 

Mr.  then  be  fixed  by  the  body  called  on  to  appraise  the  property  for  rate- 
making  purposes  about  as  follows,  the  figures  being  based  on  the 
investment  per  electric  horse-power: 

«"          Interest  on  $60,  at  6% $3.60 

"'         Amortization,  3.36% 2.02 

Taxes  and  insurance,  li% 0.90 

Maintenance   and   repairs 1.00 

General  expenses 0.70 

Operation  (wages  and  supplies) 1.00 

Total $9.22 

This  figure  is  based  on  the  total  capacity  of  the  plant,  and  is  equiva- 
lent to  $21.20  per  electric  horse-power  of  the  average  power  sold,  or 
less  than  one-third  of  a  cent  per  kilowatt-hour.  In  other  words,  if  the 
owner  of  the  property  were  allowed  a  fair  and  reasonable  return  on  his 
actual  investment  in  tangible  property,  he  would  be  required  to  furnish 
power  at  the  city  limits  at  less  than  one-third  of  a  cent  per  kilowatt- 
hour,  a  result  which  is  manifestly  absurd.  It  is  evident  that,  although 
his  actual  investment  in  tangible  property  may  have  been  determined 
properly,  nevertheless,  that  investment  does  not  in  any  sense  represent 
the  real  value  of  his  holdings,  on  which  the  rate  of  return  should  be 
determined,  and  that  this  error  is  due  to  the  omission  from  considera- 
tion of  the  value  of  a  water  right  which  cost  him  nothing. 

Furthermore,  it  would  certainly  seem  to  be  a  poor  law  which  would 
omit  from  consideration,  in  an  appraisal  for  rate-making  purposes,  a 
value  on  which  the  owner  is  taxed;  and  the  Courts  of  New  York  State, 
in  the  case  of  The  People  ex  rel.  Niagara  Falls  H.  P.  &  M.  Co.  vs. 
Smith,*  have  held  that  a  riparian  right  is  taxable.  To  deny  an  owner 
a  return  on  a  value  for  which  he  is  taxed,  whether  that  value  is 
tangible  or  intangible,  is  a  principle  which  certainly  would  not  hold 
in  law. 

The  correctness  of  including  the  value  of  a  water  right  in  the 
value  of  property  on  which  a  franchise  tax  is  to  be  levied  has  been 
upheld  in  the  case  of  The  People  of  the  State  of  New  York  ex  rel. 
vs.  the  New  York  State  Tax  Commissioners.f  This  case  was  carried 
to  the  Court  of  Appeals,  and  the  contention  of  the  State  Board  of  Tax 
Commissioners  was  fully  upheld.  It  may  be  interesting  to  note  that, 
in  this  case,  not  only  was  the  value  of  the  water  right  given  due  con- 
sideration as  affecting  the  value  of  the  entire  plant  of  the  power  com- 
pany, but  it  was  further  held  that  the  value  of  that  water  right  should 
properly  be  apportioned  to  the  several  parts  of  the  plant  in  the  same 
ratio   as   that  which   the   tangible   values  of  those  parts   held  to   the 

*70  App.  Div.,  543;  175  N.  Y.,  469. 
'     +At    an    extraordinary  term  of    the  Appellate    Division,  November  22d,  1909.    Hon. 
ti:  W.  Marcus,  Justice,  presiding. 


discussion:  appraisal  op  public  service  properties      859 

tangible  value  of  the  entire  plant.    The  principle  of  including  in  the  value       Mr. 
of  a  vrater-power  plant  the  value  of  the  water  right,  therefore,  has  not 
only  the  approval  of  common  sense,  but  the  sanction  of  the  Courts. 

Assuming  that  the  value  of  a  water-power  is  to  be  considered  in 
the  appraisal  of  a  property  for  rate-making  purposes,  the  question  then 
arises  as  to  the  method  by  which  that  value  shall  be  determined.  If 
an  actual  investment  has  been  made  for  the  acquisition  of  the  right, 
and  it  is  held  that  the  original  cost  represents  a  fair  and  reasonable 
value  thereof,  the  case  is  a  simple  one,  and  the  principle  to  be  applied 
has  been  most  clearly  and  ably  set  forth  by  Mr.  Grunsky;  but,  on  the 
other  hand,  if  no  outlay  has  been  made  for  the  water  right,  as  in  the 
illustration  just  given,  the  problem  is  a  complex  one,  and  no  doubt 
there  would  be  a  great  difference  of  opinion  as  to  the  manner  in  which 
the  true  value  should  be  ascertained. 

The  speaker  ventures  to  suggest  a  method  which  he  has  used,  and 
believes  determines  fairly  the  procedure  to  be  followed.  Reverting  to 
the  foregoing  illustration,  first  determine,  for  the  sake  of  comparison, 
what  annual  returns  a  rate-making  body  would  allow  the  owner  of  a 
modern  steam  plant  for  the  development  of  the  electrical  current  for 
which  a  sale  could  be  effected  in  the  city  under  consideration,  namely, 
10  875  e.h.p.,  average  use.  Let  it  be  assumed  that  the  investment  per 
electric  horse-power  of  rated  capacity  is  $60 ;  but,  as  the  total  capacity  of 
the  plant,  for  the  purpose  of  comparison  with  the  water-power  develop- 
ment, need  be  only  21  750  e.h.p. — the  amount  of  power  which  the  latter 
could  deliver  at  the  city  limits  at  a  suitable  voltage — the  actual  invest- 
ment per  electric  horse-power  for  purposes  of  comparison  should  be 
$52.30.  It  is  understood,  of  course,  that,  in  determining  the  rate  of  return 
which  the  owner  of  a  steam  plant  should  receive  on  his  investment,  the 
higher  value  should  be  used,  but,  as  the  comparison  is  between  a  steam 
and  a  water-driven  plant,  the  lower  value  will  be  used  in  this  illustra- 
tion. As  the  life  of  a  steam-driven  plant  will  be  less  than  that  of  the 
water-driven  plant,  it  will  be  assumed,  for  the  sake  of  comparison, 
that  the  life  of  the  former  is  15  years. 

The  comparative  fixed  charges  and  operating  expenses  for  the  steam 
plant  having  a  capacity  equivalent  to  that  of  the  water-driven  plant 
will  be  approximately  as  follows:  -^ 

Interest  on  $52.20,  at  6% $3.13 

Amortization,   5% 2.61 

Taxes  and  insurance,  li% 0.78 

Maintenance  and  repairs 1.30 

General  expenses 0.70 

Fuel  (coal,  $2.25  per  gross  ton) 13.13 

Wages  and  supplies 2.00 

it  b9£iwo  bBfi™  ,  ,  ^^„  „^ 

Total $23.65 


860     DISCUSSION :  appraisal  of  public  service  properties 

Mr.  The   speaker   recognizes   the   fact   that   there   may   be    a   material 

an  eve.  (jifference  of  opinion  as  to  the  amount  which  should  properly  be 
charged  to  the  items  of  maintenance,  fuel,  and  wages,  but  it  is  believed 
that  the  foregoing  figures  are  conservative  in  that  they  do  not  ex- 
aggerate the  operating  expenses  of  a  steam  plant,  under  the  conditions 
set  forth,  as  compared  with  those  of  a  water-driven  plant.  This  is 
shown  further  by  the  fact  that  the  total  annual  fixed  charges  and 
operating  expenses  per  electric  horse-power  are  equivalent  to  only 
0.7  cent  per  kw-hr,  of  power  development,  which  is  certainly  a  reason- 
able figure  for  a  plant  of  the  capacity  assumed. 

Assuming  the  correctness  of  the  foregoing  illustrations,  it  would 
appear  that  the  annual  return  which  would  be  allowed  by  the 
rate-making  body  to  the  owner  of  a  steam  plant  would  be  $23.65,' 
while,  if  the  value  of  the  water  right  be  disregarded,  the  owner  of  the 
water-driven  plant  would  be  allowed  to  receive  for  exactly  the  same 
service  only  $9.22,  an  annual  difference  of  $14.43.  The  unfairness  of 
such  a  proposition  is  self-evident.  If  the  owner  of  the  water-power 
plant  is  to  be  allowed  to  receive  a  like  return  for  like  services,  the  value 
of  the  water  right  must  be  determined  by  capitalizing  the  difference 
between  the  annual  yearly  expenditures  as  above  set  forth,  which  is 
$14.43.  If  it  has  been  determined  that  the  reasonable  interest  on 
money  invested  is  6%,  a  like  rate  should  be  used  in  capitalization. 
If,  however,  the  value  of  the  water  right  is  to  be  taxed  at  1%,  the 
rate  of  capitalization  to  be  used  should  be  7%,  on  which  basis  the  value 
of  the  water  right  is  $206.14  per  e.h.p.  of  rated  capacity,  an  amount 
far  in  excess  of  the  investment  per  electric  horse-power  in  tangible 
property.  To  omit  this  value  from  consideration  in  appraising  the 
property  for  rate-making  purposes  would  lead  to  a.  far  greater  error 
than  to  omit  the  entire  value  of  the  tangible  property. 

While  the  speaker  is  not  aware  that  the  Courts  have  passed  definitely 
on  the  correctness  of  the  foregoing  principle  for  determining  the  value 
of  a  water  right,  this  method  has  been  brought  before  the  Courts  in  the 
case  of  the  Fulton  Light,  Heat  and  Power  Company  vs.  The  State  of 
New  York,  and  in  the  Franchise  Tax  case  previously  referred  to. 
From  the  award  given  in  the  former  case,  it  would  appear  that  the 
Courts  certainly  gave  grave  weight  to  the  above  method  which  was  used 
in  determining  the  value  of  a  water  right.  In  the  finding  of  the  trial 
judge  in  the  case  of  The  People  of  the  State  of  New  York  ex  rel. 
vs.  The  New  York  State  Tax  Commissioners,  and  in  the  decision  of 
the  Court  of  Appeals  thereon,  no  definite  approval  of  the  foregoing 
method  for  determining  the  value  of  the  water  right  was  given,  but, 
on  the  other  hand,  there  was  no  criticism  of  it,  and  it  was  concluded 
definitely  that  the  right  had  a  value  which  should  be  considered. 
Owing  to  the  fact  that  the  appellant  set  forth  no  theory  as  to  the 
value  of  the  water  right,  but  stated  merely  that  he  had  owned  the 


DISCUSSION  :   APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES        861 

canal  for  30  years,  and  did  not  know  what  it  was  worth,  it  was  shown        Mr. 
that  there  was  no  necessity  for  the  Courts  to  pass  on  the  correctness 
of  the  theory  advanced  by  the  respondents. 

While  the  speaker  is  aware  that  opinions  will  differ  as  to  the 
methods  to  be  used  in  determining  for  rate-making  purposes  the  value 
of  water  rights,  he  has  suggested  the  foregoing  in  the  hope  that  it 
may  lead  to  discussion  and  suggestions,  and  the  advancement  of  other 
theories. 

There  can  be  no  doubt  that  the  question  is  one  which  cannot  be 
passed  over  lightly,  and  that  it  will  become  of  increasing  importance 
in  the  future,  as  water-power  development  is  proceeding  rapidly,  and 
engineers  will  be  called  on  more  and  more  frequently,  in  making 
appraisals  for  rate-making  purposes,  to  determine  the  value  of  the 
water  right  on  which  the  owner  of  a  public  service  corporation  is 
entitled  to  returns.  The  fact  that  the  water  right  cost  the  owner 
nothing,  or  that  his  investment  for  its  acquisition  was  merely  a  nomi- 
nal one,  should  have  no  real  bearing  on  such  determination. 

The  speaker  is  aware  that  the  illustration  which  he  has  used  herein 
may  be  considered  as  an  extreme  one — although  supported  by  fact  in 
actual  plants  now  in  operation — ^but  the  real  question  is  not  as  to 
whether  the  details  are  in  accord  with  the  opinions  of  all,  but  rather 
as  to  whether  the  general  principles  to  which  attention  has  been  called 
are  correct. 

W.  KiERSTED,  M.  Am.  Soc.  C.  E.  (by  letter). — The  painstaking  Mr. 
manner  in  which  Mr.  Grunsky  has  treated  the  question  of  the  appraisal  ^^^^  ^  ' 
of  public  service  properties,  particularly  for  rate-fixing  purposes,  is 
decidedly  interesting  at  a  time  when  the  valuation  of  public  utilities 
occupies  so  prominent  a  part  of  the  work  of  engineers  associated  with 
municipal  and  public  service  corporations.  The  views  appertaining 
to  matters  of  valuation  in  its  various  aspects  are  certainly  at  variance, 
although  perhaps  not  exactly  divergent.  Much  is  being  written  on  the 
subject,  and  the  efforts  of  one  who  has  given  appraisal  as  much  study 
as  the  author  appears  to  have  done,  in  order  to  outline  fundamental 
principles  and  proper  rules  of  action,  are  certainly  most  welcome, 
and  siiould  receive  the  hearty  encouragement  of  every  one  interested 
therein. 

In  1897,  the  writer's  paper,  "The  Valuation  of  Water- Works  Prop- 
erty,"* and  the  discussion  thereon,  developed  a  divergency  of  views 
which  was  to  be  expected  at  that  time.  Since  1897  the  many  calls  ' 
on  engineers  to  value  water-works  properties  and  other  public  utilities, 
for  rate-fixing,  purchase,  and  other  purposes,  have  so  inspired  the  study 
of  the  various  problems  entering  into  the  valuation  of  public  utilities 
that    to-day    suificient    experience    and    knowledge    should    have    been 

*  Transactions,  Am.  Soc.  C.  E.,  Vol.  XXXVTTI  (1807),  p.  115. 


862      DISCUSSION :  appraisal  of  public  service  properties 

Mr.  accumulated  to  admit  of  outlining  more  uniform  methods  of  valuation 
lerste  .  ^^j,  ^^^y  ^^^  ^^l  purposes  than  have  prevailed  heretofore,  were  the 
experience  in  this  line  of  work  to  be  directed  methodically,  through  con- 
certed action,  to  outlining  essential  and  fundamental  principles  and 
general  rules  of  work. 

There  may  be  no  intentional  bias  on  the  part  of  most  engineers, 
acting  individually,  in  their  efforts  to  formulate  fundamental  princi- 
ples and  rules  affecting,  and  guiding  in,  the  appraisal  of  public  service 
properties  for  rate-fixing  and  other  purposes;  but  is  it  not  true  that 
the  individual  sometimes  becomes  imbued  almost  involuntarily  with 
the  idea  that  certain  methods  or  theories  representing  the  fruits  of 
much  labor  and  of  frequent  use  are  right  simply  because  they  are 
familiar;  is  it  not  true  that  frequently  the  individual  discovers  him- 
self attempting  to  adapt  lines  of  practice  to  a  theory  worked  out  in  a 
sort  of  academic  way,  instead  of  first  studying  thoroughly  the  practical 
side  of  the  questions  involved  and  formulating  rules  and  methods  in 
accordance  with  well-established  and  good  lines  of  practice;  and  is 
it  not  true  that  the  assumptions  or  ill;istrations  often  set  forth  to 
illustrate  a  theory  are  in  part  or  wholly  incompatible  with  the  ordinary 
and  permissible  lines  of  practice,  particularly  in  arguments  presented 
in  defense  of  a  theory? 

It  seems  to  the  writer  that  one  of  the  essential  things  to  be  done, 
in  advance  of  expending  efforts  to  prescribe  rules  and  methods  to 
guide  in  the  valuation  of  public  utilities,  is  to  determine  what  the 
fundamental  principles  governing  questions  of  this  kind  may  be,  not 
necessarily  those  elaborated  in  the  office,  but  those  determined  through 
an  intimate  knowledge  of  all  the  questions  and  all  the  problems  enter- 
ing into  the  organization,  construction,  operation,  maintenance,  and 
development  of  any  public  utility.  Until  these  principles  shall  have 
been  fully  determined  and  clearly  defined,  it  is  difficult  to  conceive 
how  any  practical  theory  or  rules  of  procedure  can  be  laid  down. 

In  almost  every  article  or  discussion  relating  to  the  valuation  of 
public  utilities,  the  term  "life"  is  freely  used,  as  though  a  public 
utility  was  constructed  for  the  purpose  of  serving  a  specific  want  only 
for  some  definite  period  of  time.  This  is  fundamentally  wrong,  for 
every  public  utility  must  live  as  long  as  there  is  need  for  the  use  of  it, 
whether  the  period  of  time  be  one  year,  a  century,  or  longer.  The  error 
is  confusing,  and  arises  from  applying  to  a  composite  structure  a  line 
of  reasoning  relating  solely  to  the  life  limitations  of  various  elements 
or  units  going  to  make  up  that  structure,  apparently  without  regard 
to  its  wholly  indeterminate  life.  It  is  known  from  experience  that 
certain  units  of  a  composite  property  subject  to  heavy  wear  and  tear 
become  useless  in  time,  others  become  incapacitated  and  are  no  longer 
able  to  perform  the  functions  which  are  expected  of  them  as  part  of 
that  property,  and  others  are  abandoned  because  progress  in  the  arts 


discussion:  appraisal  op  public  service  properties      863 

and  new  inventions  compel  the  substitution  of  new  methods  and  new  Mr. 
devices  for  those  in  use.  In  this  manner,  experience  guides  in  placing  •^'"^*®  • 
a  life  limit  on  particular  units  of  a  composite  property;  but  the  same 
experience  does  not  sanction  the  placing  of  similar  limitation  on  the 
life  of  a  public  utility  considered  as  a  whole.  The  unit  may  have  an 
approximately  determinate  life,  while  the  composite  structure  possesses 
a  wholly  indeterminate  life. 

For  instance:  a  municipality  is  a  complex  and  composite  organiza- 
tion, under  State  and  Federal  regulation,  made  up  of  individual  units, 
each  unit  performing  some  particular  function  in  the  body  politic; 
each  unit  contributes  to  the  support  and  progress  of  the  municipality; 
and  each  unit,  while  concentrating  efforts  toward  its  own  business 
success,  is  contributing  constantly  to  the  progress  of  the  organized 
unit  in  which  it  lives.  All  the  units  are  blended  into  one  great 
regulated  force,  under  such  regulations  and  restrictions  for  mutual 
support  that  the  elimination,  by  death,  failure,  or  disappearance,  of 
any  unit  of  the  human  fabric  no  more  than  temporarily  affects  the 
progress  of  the  community  as  a  whole.  Every  municipal  public  utility 
is  organized  and  developed  for  the  public  need;  it  thrives  upon  and 
is  in  every  way  a  part  of  the  community.  If  the  conditions  which 
promote  the  prosperity  of  the  community  flag,  it  may  cease  to  grow, 
and  may  even  retrograde,  creating  a  business  depression  which  is  felt 
by  all  the  public  service  corporations,  and  affects  in  one  way  or  another 
even  the  humblest  individual.  On  the  other  hand,  the  prosperity  of 
the  one  follows  in  the  wake  of  the  prosperity  of  the  other.  There  is 
no  limit  of  life  to  the  community  and  its  public  utilities,  as  far  as 
human  vision  goes,  but  there  is  a  limit  to  the  life  and  period  of  useful- 
ness of  the  individual  units  in  the  community  and  of  the  personality 
of  those  engaged  in  operating  its  public  utilities. 

In  like  manner,  the  various  elements  going  to  make  up  a  composite 
property  like  a  water-works,  street-car  system,  or  similar  public  utility 
contributing  to  the  welfare,  advancement,  comfort,  and  convenience  of 
the  community,  stand  in  precisely  the  same  relation  to  the  composite 
structure  as  the  human  element  does  to  the  community  in  which  it 
lives,  prospers,  and  performs  some  specific  function. 

It  seems  to  the  writer,  therefore,  that  a  fundamental  error  is  com- 
mitted when  the  term  "expectancy,"  or  "life,"  is  applied  to  any  com- 
posite structure  as  it  would  be  applied  to  an  element  or  unit  of  that 
structure  which  is  known  from  experience  to  have  a  more  or  less  fixed 
and  definite  period  of  service.  The  structure  as  a  whole  is  an  enduring 
one,  as  long  as  there  is  a  demand  for  it  in  the  community  which  it 
serves.  To  remain  serviceable,  it  must  be  extended  and  improved  from 
time  to  time ;  its  worn-out  units  must  be  replaced  with  new,  larger,  and 
better  ones;  new  methods  of  operation  must  be  substituted  for  old  and 
antiquated  ones;  business  organizations  must  improve,  in  order  to  meet 


Kiersted 


864      DISCUSSION :  appraisal  of  public  service  properties 

Mr.  ^  the  demands  of  advancement  in  economics;  and  betterments  must  be 
made  from  time  to  time,  to  meet  the  various  rules  and  regulations 
imposed  by  those  who  have  been  made  the  guardians  of  the  public 
welfare  and  the  public  health  and  comfort.  In  short,  any  public 
utility,  to  be  of  service  to  the  community  which  it  is  organized  and 
constructed  to  serve,  must  be  maintained  in  an  efficient,  up-to-date 
condition;  and,  in  order  to  do  this,  renewals,  replacements,  and  exten- 
sions must  be  made  periodically.  It  cannot  die;  and  it  cannot  be 
allowed  to  retrograde,  as  long  as  the  community  depending  on  it  lives 
and  prospers  and  the  need  for  it  continues. 

Again,  the  progress  of  any  community  is  by  no  means  uniform. 
Certain  conditions  promote  a  rapid  growth  at  one  period  which  adverse 
conditions  at  a  subsequent  period  may  check  temporarily.  Such  periods 
of  growth  and  stagnation  arise  in  the  development  of  any  public 
utility;  nearly  every  decade  registers  a  jump  in  structural  costs  arising 
from  numerous  replacements  and  general  betterments  in  the  line  of 
progress.  A  composite  property  possessing  an  average  age  of  15  years 
may  within  2  or  3  years  have  this  average  age  nearly  halved.  Very 
seldom,  in  a  progressive  city,  does  the  average  age  exceed  20  years.  An 
illustration  of  how  quickly  the  average  age  of  a  composite  structure 
may  change  is  that  of  a.  water-works  property  which  was  purchased 
in  1909  at  an  appraised  value  of  $1 100  000,  in  round  numbers,  when 
the  average  age  was  15.5  years.  In  1912,  after  extensions  had  been 
made  aggregating  more  than  $820  000,  the  average  age  of  the  physical 
property  was  8.7  years.  The  original  construction  of  this  property  was 
started  in  1883;  extensive  changes  were  made  in  1886,  again  in  1898, 
and  again  in  1909.  Between  the  periods  of  heavy  expenditures  there 
were  longer  periods  of  a  more  moderate  rate  of  expansion. 

Another  case  illustrating  the  irregular  growth  of  a  public  utility 
is  that  of  the  water-works  of  Kansas  City,  Mo.  The  original  works 
were  built  by  the  National  Water- Works  Company  about  1875,  with 
a  water-supply  connection  in  the  Kaw  River;  in  1886  new  water-supply 
works  were  constructed  on  the  banks  of  the  Missouri  River,  and,  at 
the  same  time,  extensive  general  improvements  were  made;  in  1895 
the  city  purchased  the  water-works  from  the  private  company,  and 
made  some  large  extensions;  in  1905  further  extensive  and  costly 
improvements  were  made,  followed  by  other  costly  improvements  in 
1911.  Aside  from  these  expensive  periodical  extensions,  pipe-line 
extensions  progressed  continuously,  although  somewhat  irregularly. 
In  1912  all  the  pumping  engines  purchased  in  1895  had  been  replaced 
by  larger  and  more  expensive  machinery;  one  of  the  pumping  stations 
had  been  entirely  abandoned,  and  the  other  had  been  modified  exten- 
sively. The  purchase  price  in  1895  was  $3100  000;  the  cost  of  the 
physical  property  to-day  is  $8  000  000,  in  round  numbers ;  and  the 
average  age  is  approximately  17  years. 


DISCUSSION  :   APPRAISAL  OF  PUBLIC   SERVICE  PROPERTIES        865 

Both  these  illustrations  are  of  public  utilities  in  cities  where  the  Mr. 
growth  and  development  may  have  been  more  rapid  than  in  some  cities 
in  other  localities;  but,  however  this  may  be,  they  afford  a  practical 
example  of  how  public  utilities  are  developed — the  difference  in  the 
rate  of  development,  between  a  rapidly  growing  and  a  slowly  growing 
city,  being  one  of  degree  only.  Replacements  and  rehabilitation 
periods  may  be  at  more  frequent  intervals  in  a  city  of  rapid  growth 
than  in  one  of  slow  development,  and  the  average  age  of  a  composite 
property  may  be  somewhat  longer  in  the  latter  than  in  the  former,  but 
there  can  be  no  such  condition  in  practice  as  a  public  utility  standing 
still  and  progressively  growing  old.  If  a  community  retrogrades,  the 
value  of  the  individual  units  of  city  property,  of  the  city  property  as 
a  whole,  and  of  all  its  public  utilities,  must  depreciate;  and  the  owner 
of  a  public  utility  must  witness  the  value  of  his  investment  grow  less 
and  less  as  the  community  continues  to  retrograde. 

These  two  considerations,  namely,  the  indeterminate  life  of  a  com- 
posite structure  like  almost  any  public  utility,  and  the  comparatively 
short  average  age  under  almost  any  conditions  to  be  found  in  any  one 
of  our  American  cities,  are  believed  to  be  essential  and  fundamental, 
and  to  underlie  all  practical  methods  of  appraising  public  utilities. 

The  estimated  cost  of  duplicating  the  physical  property  of  a  public 
service  corporation  is  not  in  itself  a  measure  of  the  value  of  the  prop- 
erty; it  is  simply  an  essential  element  of  the  value  of  such  a  property. 
The  more  completely  replacements  and  substitutions  of  perishable  and 
incapacitated  units  may  have  been  made  and  the  entire  plant  may  have 
been  maintained  in  a  serviceable  condition,  the  nearer  does  the  fairly 
estimated  cost  of  the  reproduction  of  the  physical  property  represent 
its  full  reproduction  value  as  an  element  of  total  value  of  the  entire 
property.  It  is  seldom,  however,  that  this  is  the  situation  when  an 
appraisal  is  to  be  made,  and  consideration  should  be  given  to  the 
measure  or  degree  in  which  the  physical  property  falls  short  of  this 
ideal  condition. 

The  author  regards  real  estate,  or  rather  the  increment  of  value  of 
real  estate  over  and  above  the  purchase  price,  as  reinvested  earnings 
open  to  consideration  in  an  appraisal  for  rate-fixing  purposes.  This 
view  seems  to  be  entirely  consistent  with  that  generally  entertained 
at  the  present  day,  and  with  the  theory  of  valuation  based  on  the  cost 
of  reproduction  of  the  physical  property  imder  conditions  as  of  the 
date  of  valuation.  It  would  follow,  naturally,  from  the  same  line  of 
reasoning,  that  any  of  the  physical  conditions  which  increase  the 
actual  cost  of  reproducing  any  unit  or  any  aggregation  of  units  of  the 
physical  property,  as  compared  with  the  cost  at  the  time  of  construc- 
tion, may  also  be  considered  with  equal  consistency  as  reinvested 
earnings,  and,  accordingly,  should  be  included  in  the  capital  account 
subject  to  consideration  for  rate-fixing  purposes.     For  instance:   the 


866      Discussiox :  appraisal  of  public  service  properties 

cost  of  laying  water  pipes  under  paved  streets  and  in  streets  where  the 
working  force  is  subject  to  great  interference  on  account  of  the 
presence  of  underground  structures,  notwithstanding  the  fact  that  the 
pipes  were  actually  laid  in  unpaved  streets  before  the  existence  of  many 
of  the  present-day  underground  structures,  has  usually  been  regarded 
as  a  proper  element  of  value  in  connection  with  cases  where  the  valua- 
tion has  been  for  purchase  and  sale,  and  has  been  occasionally  ques- 
tioned in  connection  with  rate  cases  solely.  It  would  seem,  however, 
that  if  enhancement  of  value  in  one  particular  is  to  be  considered  in 
rate  cases,  enhancement  of  value  in  other  directions  should  be  open  to 
equal  consideration.  Furthermore,  if  enhancement  of  value  in  any 
particular  is  legitimate  and  fully  consistent  with  the  theory  of  valua- 
tion on  the  basis  of  reproducing  the  physical  property  under  present- 
day  conditions,  it  would  appear  that,  on  the  other  hand,  it  is  also 
perfectly  proper  that  all  questions  of  depreciation  of  the  value  of  the 
physical  property  should  be  given  equal  weight.  If  it  is  fair  to  allow 
enhancement  of  value,  it  must  be  equally  fair  to  consider  depreciation 
of  value;  both  are  part  and  parcel  of  any  method  of  valuation  based 
on  the  cost  of  reproduction  under  the  physical  conditions  existing  as 
of  the  date  of  valuation. 

The  computation  of  depreciation,  as  applied  to  the  appraisal  of 
public  utilities,  has  been  rendered  somewhat  complex  and  rather  incon- 
sistent by  the  infusion  of  sinking-fund  methods.  The  limited  fran- 
chise under  which  many  of  the  public  utilities  have  been  constructed 
and  operated  may  have  served  to  suggest  the  use  of  the  sinking-fund 
method  in  computing  depreciation.  The  application  might  be  proper 
enough  were  the  property  to  pass  out  of  existence  at  the  expiration  of 
a  limited  franchise,  and  were  the  rates  to  be  charged  for  public  and 
private  service  sufficient  to  return  to  the  investor  the  invested  capital 
with  interest;  but  it  is  seldom  or  never  the  case  that  the  physical  prop- 
erty expires  with  the  franchise.  There  have  been  a  very  few  instances 
where  an  investment  has  been  irreparably  injured  by  a  city  (after 
refusing  either  to  purchase  the  property  or  renew  an  expired  fran- 
chise) constructing  competitive  works  and  virtually  crowding  the  owner 
of  a  public  utility  out  of  business.  Occasions  of  this  kind  are  so  few 
as  to  be  scarcely  worthy  of  consideration  in  a  comprehensive  view  of 
the  subject,  and  have  usually  resulted  from  either  an  unfortunately 
drawn  franchise  ordinance  or  a  bitter  contention  precipitated  between 
the  owner  of  the  public  utility  and  the  city. 

Sinking-fund  computations  find  well-defined  application  to  financial 
problems  like  those  of  the  redemption  of  municipal,  state,  and  national 
bonds,  and  to  problems  like  those  involved  in  life  insurance;  but  the 
application  of  such  a  method  to  the  financial  management  of  any 
public  utility  compels  a  complication  of  accounts  which  scarcely  any 
management  of  a  public  utility  would  care  to  introduce.    Its  applica- 


discussion:  appkaisal  of  public  service  properties      867 


tion  in  this  regard  is  not  only  cumbersome,  but  conflicts  with  the  Mr. 
actual  conditions  of  practice.  Moreover,  it  is  likely  to  prove  in- 
equitable. It  compels  the  assumption  of  a  life  period  for  each  of  the 
numerous  units  entering  into  the  composition  of  a  property,  and  the 
computation  of  depreciation  by  well-known  sinking-fund  methods  for 
some  definite  portion  of  an  assumed  life  term  for  each  of  the  various 
units. 

The  assumption  of  a  life  period  for  the  units  of  a  composite  prop- 
erty and  the  computation  of  depreciation  of  the  various  units  on  the 
sinking-fund  basis  is  equivalent  to  computations  of  depreciation  on 
composite  property  having  an  equivalent  life  period.  The  operation 
of  the  sinking  fund,  as  applied  to  the  depreciation  of  a  property 
having  a  composite  life  of  60  years,  is  shown  by  Table  13. 

TABLE  13. 


Age  of  property, 
in  years. 

Percentage  of  total  de- 
preciation, with  sinking 
fund  invested  at 
3  per  cent. 

Average  annual  rate  of  depreciation 
by  decades. 

0 

0 

7 

16.5 
29.2 
46.2 
69.2 
100.0 

0.7 

0.95 

1.30 

1.7 

2.3 

S.l 

10 

1st  Decade. 

20 

2d         " 

30 

8d         " 

40 

4th        " 

50 

5th        " 

(V) 

6th        " 

The  average  of  the  six  decades  is  1.67%  per  year,  corresponding 
with  the  straight-life  method  of  depreciation  for  a  60-year  life. 

The  average  rate  of  depreciation  as  thus  computed  is  irregular; 
it  is  moderate  in  the  earlier  years  and  very  rapid  in  the  later  years- 
of  the  life  of  any  unit,  and,  in  the  long  run,  is  likely  to  result  in  an 
inequitably  proportioned  depreciation,  a  progressive  increase  of  rates- 
to  meet  interest  on  sinking-fund  investments,  and  any  number  of 
incongruities  in  accounting  and  in  attempting  to  harmonize  practice 
with  theory.  The  fact  is  that  the  sinking-fund  method  of  computing 
depreciation  assumes  the  plant  to  grow  old  continuously,  and  finally 
to  wear  out  and  pass  out  of  existence,  whereas,  in  reality,  the  plant 
usually  grows  more  efficient  as  it  grows  older,  through  necessary  and 
indispensable  replacements  of  its  various  units,  and  the  property 
becomes  more  valuable. 

The  sinking-fund  method  really  has  no  place  in  computations  of  the 
rate  of  depreciation  of  a  composite  property.  As  long  as  worn  out, 
incapacitated,  and  obsolete  units  and  methods  of  operation  are  replaced 
progressively  with  new,  improved,  and  larger  units  and  methods,  and 
the  property  as  a  whole  is  extended  and  enlarged  from  time  to  time, 
to  meet  the  demands  of  a  growing  community,  there  seems  to  be  little 


868      Discussiox :  appraisal  of  public  service  properties 

Mr.  ground  for  further  consideration  of  depreciation,  unless  it  may  be 
■  that  referred  to  as  deferred  maintenance. 

By  deferred  maintenance  is  meant  deterioration  other  than  that 
which  can  be  taken  care  of  in  the  ordinary  course  of  events  by  current 
expenditures  covering  ordinary  wear  and  tear  and  ordinary  replace- 
ments. For  instance:  as  time  goes  on,  the  discharging  capacity  or 
serving  capacity  of  the  distributing  pipes  in  a  system  of  water-works 
is  reduced  materially  by  the  tuberculation  of  their  interior  walls,  and 
this  necessitates  a  cleaning  process,  or  reinforcements,  or  replacements. 
Such  deterioration  is  usually  allowed  to  progress  until  inferior 
service  compels  the  use  of  comprehensive  and  extensive  cleaning  and 
replaxjement. 

The  average  annual  cost  of  replacements  of  four  water-works  prop- 
erties, the  histories  of  which  are  well  known  to  the  writer,  when  dis- 
tributed over  the  average  age  period  of  the  respective  properties,  is 
0.6%  of  the  cost  of  reproduction. 

In  another  instance,  a  water-works  property,  which  had  been  started 
in  1865  and  in  1907  was  found  to  have  many  of  the  older  pipes  heavily 
coated  internally,  received  a  special  depreciation  of  0.33%  per  annum 
of  the  cost  of  reproducing  the  physical  property,  representing  deferred 
maintenance. 

The  aggregate  annual  cost,  covering  replacements  and  deferred 
maintenance,  as  above  stated,  of  0.93%  of  the  cost  of  reproduction, 
represents  a  rate  of  depreciation  which  is  under  rather  than  over  that 
which  may  be  expected  to  approximate  the  rate  of  depreciation  of 
these  particular  properties,  for  the  reason  that  some  of  the  minor 
replacements  are  not  accounted  for. 

It  may  be  stated,  further,  that  the  foregoing  replacements  are  of 
the  important  parts  of  water-works,  like  pumping  machinery,  buildings, 
boilers,  settling  basins,  water-supply  intakes,  and  other  important 
units  which  are  subject  to  replacement  or  radical  changes  at  long 
intervals.  They  do  not  in  any  degree  embrace  the  expenditures  cover- 
ing ordinary  repairs  and  current  maintenance.  These  costs,  wholly  in 
excess  of  that  above  estimated,  would  by  themselves  approximate 
0.8  to  1%  per  annum  of  the  cost  of  reproducing  the  physical  prop- 
erty. In  all  probability  an  allowance  of  2%  on  the  cost  of  repro- 
ducing the  physical  property  of  a  water-works  would  represent  the 
amount  of  money  to  be  set  aside  annually  for  general  maintenance; 
about  half  of  this  would  be  used  to  cover  current  maintenance  expendi- 
tures, the  other  half  could  be  set  aside  as  a  fund  to  replace  the  worn- 
out  and  incapacitated  units,  as  becomes  necessary  in  the  ordinarj' 
course  of  events. 

The  writer  does  not  presume  to  offer  these  figures  for  general 
application,  although,  for  the  particular  properties  considered,  and  for 
similar  ones,  they  may  not  be  far  wrong.     They  serve  the  purpose  of 


DISCUSSION  :   APPRAISAL  OF  PUBLIC  SERVICE  PROPERTIES        869 

illustrating  what  the  writer  believes  is  a  simple  method  of  computing  Mr. 
the  depreciation  of  the  physical  part  of  a  water-works  property,  and  J^'®'"^'*'*- 
one  which  will  commend  itself  to  the  bookkeeper  as  well  as  to  the 
superintendent  and  other  officers  operating  a  public  utility  of  this 
particular  kind.  By  varying  the  annual  percentage  rate  in  harmony 
with  the  average  rate  of  decay  of  the  various  elements  going  to  make 
up  the  physical  property  of  public  utilities  of  other  types,  the  same 
method  may  become  equally  applicable.  Part  of  the  money  annually 
set  aside  from  the  earnings  for  general  maintenance  may  be  appor- 
tioned to  meet  the  annual  costs  of  current  maintenance  and  repairs; 
another  part  may  be  a  fund  for  use  in  making  replacements,  and  for 
any  similar  work  which  would  serve  to  perpetuate  and  insure  the 
highest  degree  of  efficiency  and  the  continued  usefulness  of  the 
physical  property. 

A  straight-line  method  of  this  kind  for  computing  depreciation 
avoids  all  the  incongruities  and  inconsistencies  of  the  sinking-fund 
method;  it  is  equitable;  it  is  practical,  and  in  accord  with  the  present 
methods  of  operating  public  utilities ;  and  it  simplifies  bookkeeping, 
and  can  perhaps  meet  general  requirements  in  this  direction  more 
nearly  than  any  other. 

In  estimating  the  present  value  of  the  physical  property  of  any 
public  utility,  it  would  simply  be  necessary  to  estimate  the  average  age 
of  the  composite  property  which  is  being  appraised,  and  deduct,  as 
depreciation  from  the  estimated  cost  of  reproduction,  an  amount  found 
by  applying  the  annual  percentage  rate  covering  replacements  and 
deferred  maintenance  multiplied  by  the  age  of  the  composite  structure. 
The  annual  percentage  rate  should  be  determined  from  general 
experience  and  from  particular  knowledge  of  the  property  under 
appraisement. 

The  monopolistic  character  of  many  public  utilities  eliminates  from 
consideration  the  question  of  the  influence  of  competition  to  such  a 
degree  as  to  render  the  method  of  computing  depreciation  herein 
proposed  more  nearly  applicable  than  would  be  the  case  were  a 
property  subject  to  the  unrestrained  influence  of  sharp  competition,  as 
may  be  the  case  in  many  private  lines  of  business. 

Passing  to  the  question  of  the  value  of  a  public  utility:  It  is  clear 
that  a  distinction  may  exist  as  to  the  value  for  rate-fixing  purposes  and 
for  purchase  and  sale,  particularly  when  circumstances  are  such  that 
franchise  value  can  properly  be  taken  into  consideration.  Where  the 
power  to  regulate  rates  is  exercised  in  accordance  with  law  by  a 
municipality  annually,  as  in  California,  or  by  a  commission,  there 
can  be  no  franchise  value;  but  it  does  not  follow  that  such  an  element 
of  value  of  a  public  utility  as  that  ordinarily  termed  "going  value"  or 
"going  concern  value"  can  be  similarly  excluded,  for  the  simple  reason 


870     DISCUSSION :  appraisal  of  public  service  properties 

Mr.  tliat  it  should  not  properly  be  classed  as  part  of  the  intangible  value, 
■  particularly  when  computed  irrespective  of  earnings.  Where  income — 
or,  more  properly  speaking,  net  income — is  used  as  a  basis  and  means 
of  computing  "going  value,"  so  called,  it  is  open  to  this  criticism,  to 
a  degree  at  least,  because  it  may  partake  in  part  of  the  nature  of  fran- 
chise value,  if  the  prevailing  rates  are  high  and  the  assumed  period 
of  time  covered  in  the  use  of  earnings  in  computing  going  value  is 
abnormally  long.  In  no  event  should  an  appraisal  for  rate-fixing 
purposes  consider  any  element  of  value  based  on  earnings  or  income. 
It  does  not  follow,  however,  that  there  is  no  element  of  value  over  and 
above  the  cost  of  reproducing  the  physical  property  together  with  usual 
overhead  charges  which  it  is  customary  to  add  to  such  computations, 
which  should  be  as  open  to  consideration  in  appraisals  for  rate-fixing 
purposes  as  for  purchase  and  sale. 

In  defining  what  the  writer  means,  he  quotes  from  his  testimony 
in  a  recent  case  where  a  commission  jointly  estimated  the  cost  of 
reproducing  the  physical  property  of  a  water-works,  allowing  all 
enhancement  of  value  due  to  existing  market  and  physical  conditions, 
and  deducting  for  depreciation.  The  element  of  value  referred  to  in 
that  line  of  testimony  was  defined  as  "going  concern  value." 

"The  method  of  computing  'going  concern  value'  assumes  that  the 
knowledge  of  the  general  public  with  regard  to  the  water  service  is 
fully  developed,  it  assumes  that  the  business  of  the  existing  plant, 
its  patronage,  etc.,  remains  intact  until  delivered  to  the  new  plant. 
No  longer  time  is  needed  for  the  recovery  of  business  than  is  neces- 
sary to  render  the  new  property  administratively  and  mechanically 
fit  and  serviceable  for  conducting  the  entire  business  of  the  old  prop- 
erty, allowing  proper  time  and  capital  for  making  the  service  connec- 
tions, the  getting  of  machinery  into  proper  working  order,  elimination 
of  all  defects  of  construction,  the  duplication  of  the  office  records,  and 
the  perfection  of  the  business  and  mechanical  organization." 

Nearly  all  the  elements  of  value  entering  into  the  computation 
of  the  "going  concern  value,"  as  above  described,  represents  tangible 
property  in  one  form  or  another,  and  may  very  properly  embrace  an 
additional  element  of  operating  capital.  As  thus  described,  the  going 
value  has  no  relation  to  the  earnings  of  the  property,  the  reproduction 
cost  of  which  is  being  estimated.  It  may  be  computed  as  a  percentage 
of  the  cost  of  reproducing  the  physical  property,  or  in  any  similar 
manner. 

As  thus  defined,  the  going  value  loses  all  connection  and  relation 
with  so-called  intangible  value;  in  fact,  many  of  the  units  entering 
into  or  going  to  make  up  this  going  concern  value  are  susceptible  to 
decay,  as  are  other  portions  of  the  physical  property,  and,  in  rate- 
fixing  cases,  should  have  a  percentage  of  earnings  set  aside  to  cover 
general  maintenance  as  well  as  interest  on  the  money  thus  invested. 


discussion:  appeaisal  of  public  service  properties      871 

In  appraisals  for  purchase  and  sale,  there  is  an  additional  element  Mr. 
of  value  which  may  be  properly  considered,  in  order  to  compensate  a 
successful  and  efficient  management.  Just  what  this  increment  of 
value  should  be  can  only  be  determined  in  specific  instances,  in  the 
light  of  all  the  facts  relating  to  the  business  organization  and  the 
progressiveness  of  the  municipality  furnishing  the  patronage  for  the 
public  utility  under  appraisement.  While  this  increment  of  value 
would  not  be  considered  in  rate-fixing  cases  as  part  of  the  capital 
investment,  the  rates  could  be  adjusted  so  as  to  support  through 
surplus  earnings  an  increment  of  value  sufficient  to  invite  investments 
in  a  public  utility  of  the  kind  under  appraisement,  and  to  encourage 
intelligent  and  efficient  management.  A  community  which  has  had  the 
benefit  of  such  a  management  can  well  afford  to  pay  something  more, 
for  a  property  which  is  well  organized  and  well  managed,  than  it 
would  be  willing  to  pay  for  one  where  the  situation  is  reversed. 

On  the  other  hand,  a  mismanaged  property,  where  earnings  have 
been  sufficient  to  pay  a  fair  return  on  the  invested  capital  and 
maintain  the  property  in  an  efficient  condition,  but  have  been  diverted 
from  the  natural  and  proper  channels,  should  expect  and  should  receive 
nothing  short  of  heavy  depreciation  of  value  in  an  appraisal  of  the 
property,  either  for  rate-fijxing  purposes  or  for  purchase  and  sale. 
Such  considerations  as  these,  entering  into  the  investigations  leading 
to  a  final  conclusion  on  the  value  of  a  public  utility,  as  they  properly 
should  enter,  involve  the  intelligent  judgment  of  the  appraiser,  and 
force  him  out  of  the  "strait- jacket"  of  reasoning  through  mathemati- 
cal formulas  or  any  set  of  rules  based  thereon. 

It  does  not  always  follow,  however,  that  the  value,  either  for  rate- 
fi^xing  purposes  or  for  purchase  and  sale,  will  be  invariably  equitable 
when  computed  on  the  basis  of  the  cost  of  reproduction,  for  the  simple 
reason  that,  in  exceptional  cases,  it  may  give  a  value  in  excess  of  that 
at  which  a  community  can  either  afford  to  purchase,  or  support 
through  its  patronage.  One  instance  of  this  kind  in  the  writer's 
experience  is  of  a  town  which  retrograded,  losing  perhaps  40%  of  its 
population  during  the  period  in  which  the  public  utility  had  been  in 
operation.  In  this  instance  there  could  be  no  question  but  what  the 
public  utility  corporation  would  have  to  share  in  the  shrinkage  of 
values  resulting  from  reduced  patronage  and  the  inability  of  the  town 
to  meet  obligations  which  otherwise  they  could  have  met  had  the  town 
continued  to  increase  in  population  and  taxable  value  at  the  same 
average  rate  as  it  did  during  its  prosperous  career. 

In  view  of  the  many  uncertainties  surrounding  the  appraisal  of 
public  utilities,  it  would  seem  to  be  well-nigh  impossible  to  formulate 
any  set  of  rules  to  guide  appraisers  in  estimating  value  except  those 
which  are  of  very  general  application  and  embrace  the  more  funda- 
mental principles  relating  to  and  governing  work  of  this  character. 


872      DISCUSSION:  appraisal  of  public  service  properties 

Mr.  The  writer  is  not  one  who  believes  the  Courts  have  led  engineers 

Kiersted.  -j^^^  error  in  performing  their  part  of  the  work  relating  to  the 
appraisement  of  public  utilities.  The  whole  province  of  the  engineer 
in  a  matter  of  this  kind  is  to  assist  the  Court  by  his  evidence,  and 
when  engineers  of  wide  experience,  but  representing  opposing  interests, 
present  views  widely  at  variance  on  matters  regarding  which  they  are 
supposed  to  have  an  intimate  knowledge,  the  Court  is  certainly  to  be 
excused  if  the  evidence  is  practically  set  aside  or  only  partly  con- 
sidered. As  a  rule,  the  estimates  of  engineers  of  experience  on  the 
cost  of  reproducing  a  physical  property  should  not  and  will  not  vary 
materially.  In  fact,  a  joint  conference  of  engineers  representing 
opposing  parties  will  frequently  result  in  a  joint  agreement  as  to 
values,  except  possibly  on  the  question  of  the  overhead  charges  which 
it  is  customary  to  allow  in  the  appraisement  of  public  utilities,  and 
on  questions  involving  going  value — elements  of  value  which  can  be 
settled  quite  as  readily  by  the  Court  itself  after  hearing  individual 
testimony.  Joint  agreement  on  most  or  all  of  the  technical  details,  in 
advance  of  the  hearing  of  evidence  and  the  filing  of  a  joint  report  as 
the  evidence  of  all  the  engineers,  would  greatly  abbreviate  the  work 
of  all  concerned,  and  perhaps  simplify  and  materially  assist  the  work 
of  the  Court  itself,  but,  unfortunately,  in  most  instances,  counsel  of 
the  opposing  parties  do  not  sanction  the  joint  conference. 

One  word  more,  in  order  to  make  more  clear  the  writer's  position 
with  regard  to  capital  investment :  The  earnings  covering  depreciation, 
in  the  sense  in  which  the  writer  has  used  depreciation,  are  expected, 
among  other  things,  to  return  to  the  investor  the  cost  of  abandoned 
property.  Accordingly,  as  property  is  abandoned  it  should  be  charged 
off  the  capital  investment  account,  and,  in  a  similar  manner,  any  unit 
substituted  for  an  abandoned  unit  should  be  added  to  capital  invest- 
ment account.  Thus  the  accounts  would  show  the  total  investment  as 
well  as  the  active  or  present  investment  at  any  date  of  valuation. 

Whatever  of  criticism  there  may  be  in  these  remarks  attaches  to 
the  writer  with  perhaps  even  more  force  than  to  Mr.  Grunsky,  for 
the  writer  has  used  the  sinking-fund  method  in  computing  deprecia- 
tion in  numerous  instances,  but  believes  that  in  it  he  has  observed 
fallacies  which  should  be  eliminated,  even  though  it  involves  the  dis- 
carding of  sinking-fund  methods  and  the  radical  modification  of  past 
lines  of  procedure.  He  has  nothing  but  thanks  and  congratulations  to 
offer  the  author  for  presenting  in  such  a  comprehensive  manner  the 
results  of  his  labors,  and  hopes  that  the  issues  which  are  thereby 
raised  will  be  discussed  fully  and,  finally,  will  result  in  simplifying 
and  improving  the  methods  used  in  the  valuation  of  public  service 
properties. 

Mr.  C.  E.  Grunsky,  M.  Am.  Soc.  C.  E.  (by  letter). — The  point  which 

runs  y.  ^^^  -writer  particularly  desired  to  emphasize  in  the  paper  was  that  when 


I 


discussion:  appraisal  of  public  seevicb  peopertibs      873 

rates  are  to  be  fixed  the  investor  in  public  service  properties  is  entitled  Mr. 
to  adequate  protection.  The  method  of  securing  this  protection  in-  ^'""'"s'^y- 
telligently  was  described,  and  the  writer  tried  to  make  clear  that 
there  should  always  be  an  allowance  in  some  form  and  under  some 
name  to  compensate  the  owner  of  the  public  service  property  for 
hazard,  and  for  management  both  during  construction  and  under 
operation.  This  compensation  should  appear  in  the  rate  of  interest  to  be 
earned  rather  than  in  the  appraisal  on  which  interest  is  to  be  allowed. 
Placing  it  in  the  appraisal  is  a  convenient  way  of  making  the  earnings, 
expressed  in  percentage  thereof,  appear  low.  In  whatever  way  this  may 
be  handled,  something  more  than  ordinary  interest  on  the  properly 
invested  capital  should  appear  in  the  earnings,  if  these  have  been 
equitably  fixed. 

There  is  no  intent  to  advocate  the  taking  of  any  property  without 
due  compensation,  as  Mr.  Higgins  seems  to  infer  from  parts  of  the 
paper.  When  the  broad  principle  is  laid  down  therein  that  the  owner 
of  a  public  service  property  is  entitled  to  be  protected  to  the  extent 
of  his  investment,  first,  in  the  matter  of  receiving  thereon  a  proper 
return,  and,  second,  in  having  the  invested  capital  itself  protected 
and  ultimately  returned,  this  is  not  to  be  understood  in  a  strictly 
restrictive  sense.  There  may  be  elements  not  covered  by  actual  in- 
vestment, which  are,  nevertheless,  essential  parts  of  the  property  and 
represent  investment  even  though  never  actually  paid  for  by  the 
owner,  and  not  appearing  as  having  cost  him  anywhere  near  their 
market  value.  In  such  cases,  however,  it  will  generally  be  well  to 
inquire  into  the  circumstances  attending  their  acquisition. 

Water  rights,  such  as  Mr.  Van  Cleve  cites,  are  to  be  considered 
as  property  which  has  value.  As  part  of  a  public  service  property,  they 
may  or  may  not  represent  actual  investment.  Such  water  rights,  never- 
theless, are  to  be  classed  as  elements  to  be  included  in  the  appraisal. 
Probably  no  hard-and-fast  rule  can  be  laid  down  for  determining 
their  value  in  the  sense  of  what  it  might  reasonably  be  assumed 
that  they  would  cost  if  they  had  to  be  acquired  from  other  owners. 
The  circumstances  attending  the  valuation,  particularly  of  unde- 
veloped water  rights,  are  so  varied,  involving  as  they  do  all  the  un- 
certainties of  present  and  future  demand  for  power,  that  any  satis- 
factory and  conclusive  suggestion  along  this  line  is  hardly  to  be  hoped 
for  at  this  time. 

In  California  the  flowing  water  belongs  to  the  people,  but  the 
riparian  owner  on  a  stream  has  certain  paramount  rights.  A  distinc- 
tion is  to  be  made,  therefore,  between  a  water  right  in  the  broad  sense  in 
which  it  is  here  generally  referred  to,  when  it  is  strictly  a  grant  by  the 
people  on  a  par  with  a  franchise,  and,  in  the  more  restricted  sense,  com- 
parable with  the  illustration  used  by  Mr.  Van  Cleve,  in  which  case 
the  power  right  is  the  property  of  the  riparian  owner.     In  the  one 


874      DISCUSSION :  appraisal  of  public  service  properties 

case  the  water  right  deserves  the  same  treatment  as  a  franchise;  in 
the  other  case  the  fact  that  it  has  a  market  value  is  easily  recognized, 
and  its  appraisal  is  a  comparatively  simple  matter. 

In  reply  to  the  question  which  Mr.  Boucher  asks  concerning  the 
appraisal  of  property  such  as  a  valuable  right  of  way  which  cost 
little  or  nothing,  the  circumstances  in  each  case  should  be  taken  into 
account.  In  the  case  which  he  cites,  the  railroad  is  not  entitled,  in 
strict  equity,  to  a  return  on  the  full  amount  that  the  property  would 
cost  to-day,  but  only  on  a  fair  allowance  for  investment.  In  other 
words,  there  should  be  some  limit  to  the  right  to  a  return  on  the  un- 
earned increment  represented  by  the  present  high  value  of  the  right 
of  way,  if  such  value  be  measured  by  what  it  would  cost  if  it  had 
to  be  acquired  to-day.  This  view  appears  to  be  in  accord  with  the  rul- 
ings of  the  Courts,  which  would  give  to  the  public  service  concern, 
practically  as  a  bonus,  the  appreciation /^m  tne  value  of  such  prop- 
erties. What  shall  be  considered  excessive  appreciation,  is  a  question 
which  had  best  be  answered  only  as  special  cases  arise. 

A  similar  question  is  that  relating  to  the  treatment  of  donations. 
Take,  for  example,  a  water  company  which  is  called  on  to  extend  its 
service  into  new  territory  not  yet  built  on,  the  owners  of  which  con- 
struct a  distributing  system  of  pipes  and  house  connections  and  all 
that  goes  toward  a  satisfactory  service  and  donate  the  same  without 
cost  to  the  water  company.  To  add  the  cost  of  such  property  at  once 
to  the  capital  invested  by  the  water  company  might  work  hardship 
and  be  unfair  to  the  older  consumers.  When  the  new  territory  is 
developed,  and  the  consumers,  resident  therein,  take  a  fair  share  of 
the  water,  it  may  well  be  asked  whether  or  not  in  fixing  rates  the 
fact  should  be  taken  into  account  that  a  part  of  the  system  was  donated 
by  the  water  users  themselves.  It  would  be  equitable  to  deduct  dona- 
tions from  the  appraisal,  allowing,  however,  adequately  for  the  upkeep 
of  the  entire  system,  including  depreciation.  On  the  other  hand,  there 
is  good  basis  for  the  view  that  it  makes  no  difference  how  the  prop- 
erty is  acquired,  and  that  the  appraisers  for  rate-fixing  purposes 
should  ignore  the  fact  that  some  of  it  may  have  cost  nothing. 

The  difficulty  that  confronts  the  rate-fixing  body  in  matters  of 
this  kind  arises  from  the  generally  accepted  theory  of  the  past — 
as  advanced  by  owners  of  public  service  properties — that  they  are 
entitled,  as  profit,  to  whatever  they  can  get  in  the  shape  of  bonus  and 
also  to  the  full  amount  of  the  unearned  increment,  represented  by 
increased  value  of  the  elements  which  go  to  make  up  the  whole  of  the 
property.  In  order  to  avoid  controversy  in  the  future,  these  matters 
should  be  made  clear,  and  it  is  by  the  general  recognition  of  funda- 
mental principles  that  this  can  be  brought  about  and  misunderstand- 
ings avoided. 

The  question  is  asked  by  Mr.  Coombs  as  to  whether  high  dividends 


discussion:  appraisal  of  public  service  properties      875 

paid  in  the  past  should  be  taken  into  account  in  making  appraisals.  Mr. 
In  a  general  way,  yes.  Consideration  may  be  given  to  this  fact  just  "^""^  ^' 
as  well  as  to  the  fact  that  there  have  been  lean  years.  Ordinarily 
high  dividends  would  hardly  be  construed  as  repayment  of  invested 
capital,  but  when  such  dividends  have  been  paid  to  the  detriment 
of  the  property,  when  proper  foresight  has  not  been  exercised  in 
making  provision  for  its  expansion,  when  the  requirement  for  de- 
ferred maintenance  is  high,  it  may  be  that  such  conditions  are 
due  in  part  to  the  high  dividends  that  have  been  paid,  and  this  is 
then  a  circumstance  to  be  considered. 

The  method  of  dealing  with  depreciation,  as  indicated  by  Mr. 
Kiersted,  is  noted  in  the  paper  as  applicable  to  any  public  service 
property  in  which  the  depreciation  may  fairly  be  considered  equivalent 
to  the  average  annual  replacement  requirement.  This  is  set  forth 
in  Paragraph  14  of  the  fundamental  principles  and  elsewhere.  The 
bookkeeping  in  such  a  case  would  be  as  Mr.  Kiersted  describes  it. 

Such  elements  of  value  as  those  enumerated  by  Mr.  Kiersted 
under  his  definition  of  "going  concern"  may  properly  be  included 
in  a  valuation,  and  perhaps  the  designation,  "going  concern,"  is 
properly  applied  to  them.  Against  their  inclusion  no  protest  is  raised. 
The  protest  which  is  implied  in  the  paper  relates  to  the  addition  of 
intangible  values,  whether  under  this  or  other  designations,  to  a 
demonstrable  investment,  or,  as  is  more  frequently  the  case,  to  an 
estimated  value  less  depreciation,  in  order  to  bring  the  same  up  to 
what  the  appraiser  thinks  it  ought  to  be.  If  there  is  to  be  any 
addition  to  the  investment  appraisal,  let  this  be  clearly  stated,  and 
it  will  make  no  difference  under  what  designation  it  is  added;  or, 
as  pointed  out  in  the  paper,  let  the  appraisal  be  made  without  deduc- 
tion of  depreciation,  and  let  the  percentage  rate  of  earnings  be  suf~ 
ficiently  high  to  do  full  justice  to  the  owner  of  the  property. 

In  closing,  the  writer  wishes  to  express  his  appreciation  of  the 
reception  which  his  paper  has  received  and  to  thank  those  who  have 
contributed  to  the  discussion  for  emphasizing  and  making  more  clear 
some  of  the  thoughts  which  were  but  imperfectly  presented. 

In  this  connection  attention  may  be  called  to  Mr.  Kiersted's  ampli- 
fication of  the  writer's  brief  comment  on  the  perpetual  life  of  com- 
posite public  service  properties.  This  idea  was  incorporated  by  the 
writer,  in  1901,  in  a  report  on  the  appraisal  of  the  properties  of  the 
Spring  Valley  Water  Company,  which  is  the  company  supplying  San 
Francisco  with  water.  If  properly  applied  the  assumption  of  per- 
petual life  will  be  found  helpful  in  many  cases  where,  for  a  plant 
taken  as  a  whole,  no  fiLxed  or  definite  term  of  life  can  be  assumed. 

In  the  case  of  a  complex  plant,  such  as  was  then  under  con- 
sideration, it  was  reasonable  to  fix  its  probable  life  at  so  long  a 
period  that  it  might  be  called  perpetual.    Parts  of  it  would  deteriorate 


Qrunsky 


876      discussion:  appraisal  of  public  service  properties 

Mr.  and  go  out  of  use;  parts  of  it,  except  for  the  highly  improbable 
case  of  its  being  killed  by  a  competing  system,  would  continue  in  ser- 
vice practically  for  all  time.  As  a  whole,  therefore,  and  for  rate- 
fixing  purposes,  it  could  be  considered  as  being  always  in  good  con- 
dition. There  was  no  need  of  writing  oS  depreciation.  The  replace- 
ment of  such  parts  as  went  out  of  use  could  be  cared  for  under 
maintenance  and  operation.  ,u 

This  idea  naturally  resulted  in  the  adoption  of  a  method  of  calcula- 
tion described  in  the  paper  as  the  method  under  which  no  deduction 
need  be  made  for  depreciation  in  valuing  public  service  properties 
for  rate-fixing  purposes. 


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